Fixed Income Market Trends and Perspective
Blocking and Tackling
Taxes Matter – Municipal Bonds have been a sound investment
Balanced Portfolios – Fixed income serves a role in a diversified portfolio
Global Growth Model
Growth Matters
Emerging Market Debt example
Market Environment
Since late 2002, risk has been rewarded
Valuations appear rich
The challenge of mean reversion evaluation
Structural Market Change
WIN – Whip Inflation Now – Did we win ?
How about the rest of the world ?
Globalization and convergence
Key Players and Impact
Derivative Instruments
Conclusion
Heraclitus and his takeaway
1
Blocking and Tackling – fundamentals review
•
In an environment where many market prognosticators have forecast a low
return environment, after tax investment considerations become important
•
After adjusting for taxes, municipal bonds have been a sound investment outright
Tax Adjusted Total Returns vs. Volatility
10 Years ending 9/30/06
13%
Annualized Return
12%
11%
Municipal HY
10%
Municipals
9%
S&P 500 (15.45%)
8%
7%
Agg
6%
5%
0.02
0.03
0.04
Credit
US Treasuries
0.05
High Yield
0.06
0.07
0.08
0.09
0.1
Annualized Standard Deviation
Credit is represented by the Lehman Brothers (LB) U.S. Credit Index, U.S. Treasuriesare represented by the LB Treasury Index, High Yield is represented by
2
the LB High Yield Index, Municipal High Yield is represented by the LB LB Tax Free High Yield Index. Municipal returns have been adjusted based on a 35%
income tax bracket assumption. Past performance cannot guarantee future results.
Blocking & Tackling – fundamentals review
Fixed Income plays a key role in diversified portfolios
September 30, 1996-September 30, 2006
10
100% Stocks
50%/50% Stocks/Bonds
Return (%)
8
6
100% Taxable Bonds
4
0
2
4
6
8
10
12
14
16
Risk (Standard Deviation, %)
50/50 Stock/Bond returned 91% of the all-stock return with 50% of risk;
75/25 Stock/Bond returned almost 97% vs. all-stock with 75% of the risk.
Stocks = S&P 500 Stock Index, Taxable Bonds = Lehman U.S. Aggregate Bond Index
Source: Lehman Brothers, Bloomberg
3
Blocking & Tackling – fundamentals review
The Global Growth Model
China
Commodities
U.S. Rates
Japan,
China etc.
Exports
U.S.
Current Account
•With its voracious appetite for commodities, China (akin to late 19th
century America) is a global growth engine.
•With its 7% / GDP current account deficit largely funded with foreign
fund flows, the U.S. is a global growth engine.
•Europe and India also play key roles
4
Blocking & Tackling – fundamentals review
Growth Matters
GDP Growth vs. High Yield Spreads
March 30, 1990 - June 30, 2006
Annualized Real GDP Growth
8
Credit Suisse High Yield Index Spread
1100
1000
6
4
800
2
700
600
0
500
-2
400
Source: Bureau of Economic Analysis, Credit Suisse
03
/3
0/
06
03
/3
0/
05
03
/3
0/
04
03
/3
0/
03
03
/3
0/
02
03
/3
0/
01
03
/3
0/
00
03
/3
0/
99
03
/3
0/
98
03
/3
0/
97
03
/3
0/
96
03
/3
0/
95
03
/3
0/
94
03
/3
0/
93
03
/3
0/
92
300
03
/3
0/
91
03
/3
0/
90
-4
5
Spread (basis points)
Real GDP % change
900
Blocking & Tackling – fundamentals review
A strong commodity run has been a catalyst for emerging
countries and contributed toward “convergence”
J.P. Morgan Emerging Market Bond Index (EMB)
200
70
0
80
EMB spreads (L)
Oil prices
60
Dec-06
400
Dec-05
50
Dec-04
600
Dec-03
40
Dec-02
800
Dec-01
30
Dec-00
1000
Dec-99
20
Dec-98
1200
Dec-97
10
Dec-96
1400
Dec-95
0
Dec-94
1600
Dec-93
EMB spreads
EMB spreads and oil prices
Oil prices (R)
Source J.P. Morgan
6
Market Environment
Since 2002 risk has generally been handsomely rewarded
Risk-Return Table
January 2003 - December 2006: Annualized Stats
MSCI EM (EMERGING MARKETS)
JPM EMB Global Index (jpmrg)
Credit Suisse High Yield Index
Credit Suisse High Yield CCC/Split CCC
Russell 2000 Value
NASDAQ Composite
S&P 500
Lehman US Aggregate Bond Index
Return
36.89
14.33
13.15
19.97
23.26
16.74
14.74
3.80
Std Dev Sharpe Ratio
16.8
2.03
7.01
1.67
4.38
2.40
8.26
2.09
13.35
1.54
13.71
1.03
8.28
1.46
3.75
0.34
Source: Zephyr Style Advisor
7
Market Environment
Valuations appear rich
JPM Global HY Index & LB Aggregate – Spreads
January 11, 2004 through January 11, 2007
JP Morgan Emerging Market Debt Spreads over US
Treasuries – December 1990 through January 2007
EMD Yield Spread Over U.S. Treasuries
650
550
2500
2000
450
1500
350
1000
250
500
150
01/06/05
01/03/03
12/29/00
12/30/98
12/26/96
12/28/94
1/2/04 3/22/04 6/10/04 8/29/04 11/17/04 2/5/05 4/26/05 7/15/05 10/3/05 12/22/05 3/12/06 5/31/06 8/19/06 11/7/06
12/28/92
50
0
12/31/90
1
Source: Bloomberg and Lehman Point
Source: JP Morgan
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Market Environment
The challenge of mean reversion analysis
% Investment grade
50%
% Investment Grade
40%
% Investment grade
30%
20%
10%
0%
Dec-93 Dec-94 Dec-95 Dec-96 Dec-97 Dec-98 Dec-99 Dec-00 Dec-01 Dec-02 Dec-03 Dec-04 Dec-05 Dec-06
Historic spread analysis does not capture qualitative or structural change
In the case of EMD, a favorable commodity cycle in conjunction with:
Fiscal discipline
Change in ownership base – pension funds
Abandonment of fixed exchange rate regimes
Convergence
Global search for yield
9
Structural Market Change – WIN
•
Whip Inflation Now – it looks like the inflation war has been won in the US
Annual Growth Rate of CPI
15%
10%
5%
0%
1975
1985
1995
2005
Source: International Monetary Fund
10
Structural Market Change – What about the rest of
the world ?
World Inflation Rates
40
35
30
25
20
15
10
5
0
2007
2006
2005
2004
2003
2002
2001
2000
1999
1998
1997
1996
1995
1994
1993
1992
1991
1990
Source: International Monetary Fund
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Structural Market Change – Globalization & Convergence
“ In a nutshell, I believe that the factors of globalization, deregulation, and financial
innovation, arising partly in response to episodes of high inflation, have effectively
eroded the central bank monopoly on the provision of monetary services and have
enhanced global competition among currencies. These changes have, in turn, altered the
incentives for central banks to behave badly and for finance ministries to use central
banks as "piggy banks" to finance their fiscal policies. The resulting constraint on
monetary policy, combined with increased public understanding of the costs of inflation,
have led to institutional changes in central bank governance that bolster their credibility
for maintaining price stability in the future. Improved central bank performance and
credibility, thus, are the consequences of this combination of factors.”
Source: Remarks by Federal Reserve Governor Randall S. Kroszner
At the Cato Institute Monetary Policy Conference, Washington, D.C.
November 16, 2006 “The Conquest of Worldwide Inflation
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Structural Market Change – Globalization & Convergence
A global trading club (with rules):
• European Union – Economic guidelines for entry
• Global standards for trade - International Organization
Standards (ISO) - together with IEC (International Electrotechnical
Commission) and ITU (International Telecommunication Union) - has built a
strategic partnership with the WTO (World Trade Organization) with the
common goal of promoting a free and fair global trading system
Source: http://www.iso.org
13
Structural Market Change – Key Players and Impact
•
Hedge Funds – Lehman Brothers research estimates there are currently 9,000 hedge funds
managing approximately $1.7 trillion in assets
•
Private Equity – Strong flows into private equity in conjunction with the willingness of private
equity players’ to “partner” has increased the pace and scale of LBO activity.
In the 18 months prior to August 2006, nine of the ten largest buyouts
in history have been announced or completed. (source T. Rowe Price)
•
Pension Funds – The Pension Protection Act passed in July 2006 directly impacting
approximately $1.6 trillion in DB pension assets. Although different than the US, it is generally
believed that the inversion of the yield curve in the U.K. has largely been attributable to a version
of pension reform
•
Tender Option Bond (TOB) Programs – Structurally designed to provide institutional clients with
yield by essentially borrowing short, investing long and adding a degree of leverage to amplify the
yield. Is generally believed to be a strong contributor to flatness of today’s municipal curve
14
Structural Market Change – Derivatives
Not a dirty word
When used in moderation, derivatives can increase the efficiency of the
portfolio management process and aid in risk management
Instruments that fall under this label include:
•
Futures – can be used to manage interest rate risk. Favorable on certain bonds that have a
degree of illiquidity, but concerned with near term valuation, a short interest rate futures trade can
provide a hedge
•
Options – In international portfolios, can be long on a currency option to hedge interest rate risk
at the country level
•
Credit Default Swaps – A tool for managing risk at security specific and market levels. Other
practical applications as well
15
Conclusion – What can we learn from Heraclitus
Heraclitus - A Greek philosopher of the late 6th century
BC, who said, “You can never step into the same river;
for new waters are always flowing on to you."
In an age of abundant data, historical information provides an invaluable frame of
reference for making investment decisions today. Qualifying an historical perspective
with an understanding of how the world today is unique relative to the past is an even
more potent formula for success. As the French found out in the late 1930’s, while a
formidable structure, the Maginot Line was not built for the type of warfare that unfolded
during the Second World War.
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Final appendix
•
•
•
•
•
•
•
•
•
Past performance cannot guarantee future results.
All charts are for illustrative purposes only and not meant to represent an investment in any
particular security. It is not possible to invest directly in an index.
Diversification cannot assure a profit or protect against loss in a declining market.
Risks:
Interest Rate risk: This is the decline in bond prices that usually accompanies a rise in interest
rates. Longer-maturity bonds typically decline more than those with shorter maturities.
Credit risk: This is the chance that any fund holding could have its credit rating downgraded, or
that a bond issuer will default (fail to make timely payments of interest or principal), potentially
reducing the fund's income level and share price.
High-Yield Investing
A fund investing in high-yield corporate bonds, often called "junk bonds," could have greater price
declines than funds that invest primarily in high-quality bonds.
Emerging market Risk: Investments in emerging markets are subject to abrupt and severe price
declines, and should be regarded as speculative. The economic and political structures of
developing nations, in most cases, do not compare favorably with the U.S. or other developed
countries in terms of wealth and stability, and their financial markets often lack liquidity.
Derivatives: Investing in derivative instruments may involve substantial risk. The risks of
investing in derivatives should be carefully weighed as it is possible to lose more than the amount
invested.
17