September 28, 2021 | Cameron Parkhurst
Well…we are finally seeing hints of some more than minor volatility out there in equities. Some analysts at major firms are calling for 10-20% market reversals on the horizon, due partially to the China Evergrande credit story, but also the potential for disappointing earnings reports. We are still evaluating the Evergrande situation to evaluate whether subsidiaries will have further financial difficulty as well. Either way, it has the markets a bit nervous. It likely does not have major implications for the investment grade markets that we delve in but could deliver more broad high yield and equity sector volatility.
This begs the question as to what might happen should we get a large-scale pullback in the face of the Fed having ongoing tapering discussions. There is the potential that this tapering story/decision could get delayed should a large-scale pullback happen. However, some analysts are beginning to focus more on Fed transparency, and thus the FOMC dot plot models. There is banter that this could prove to show a bit more hawkishness and thus we could see a flight to safety if that were to unfold.
Interestingly enough, things have been extremely complacent in the bond market for the last 6 weeks leading up to the last few days of rising short-term Treasury rates. Check out munis, for example, relative to Treasuries. We have been in almost 6 weeks of doldrums:
There has been almost no movement on yield. It seems many traders haven’t wanted to move markets much, because of the consistent ebb and flow of the $3.5 trillion entitlement and climate plan and whether munis, both taxable and tax free will be included. The advanced refunding component would be huge as well and would likely open up the market significantly. As of now, most of the muni verbiage is seemingly back out of the plan, so to some extent we are in the same boat, waiting to see what our friends in D.C. will accomplish.
However, we may see some upward yield movement in the weeks ahead, as munis typically have a short lag effect versus Treasury moves. With the tapering discussions seemingly taking the lead, and there being discussion of the beginning of taper in November, new issue Treasury auctions were weak on Monday and front-end rates hit yearly highs.
This is indicative of the Fed pulling up the anchor, and this could lead to rising rates for a short period of time as things adjust to the floor being removed or at least moving higher.
With our typical focus being relative value with a muni focus, we often find some charts and graphs more interesting than others. This one is on that level:
It’s amazing to watch the inflows into the muni fund and ETF market here, essentially sucking up almost any new issue demand that comes to the table. Upwards of $85 billion has gushed into the muni market since January. More interestingly, there is a very large concentration in just a few muni players. Essentially 10 firms have garnered most all the managed muni fund money. Knowing that our muni sandbox is very retail oriented, this is worrisome for us to see those piling into these heavily concentrated managed funds.
With this limited number of participants, what happens when we do get a pinch of bond market panic and a sell-off? We have always been concerned and have warned about Net Asset Value risk inside of traditional bond funds. This is likely not eminent tomorrow, but we will see it rear its head at some point. When that happens, because of this manager concentration in a retail driven market, our fear is that we could see funds selling off in price and forcing liquidations into a sloppy muni market.
This is where we come in for our Institutional clients. During those times, we are extremely happy to buy high quality paper at significant discounts on the bid side. For the buy and hold, bond ladder builder/investor, this can be an ideal scenario to add good yield to a portfolio. We buy when we get a cheaper market and hold onto this paper until things settle down. We let other bonds mature and consistently reinvest back into the market.
This buffers us a good bit from interest rate movements and allows us to sell back to the market with significant upside should we encounter a big rally like we saw at the beginning of the COV-19 crisis. Thus, we don’t mind keeping a little powder dry…just in case!
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Thanks,
Your PeachCap Fixed Income Team
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