February 25, 2021 | Cameron Parkhurst
Groundhog Day came and went earlier in the month. Punxsutawney Phil emerged from his burrow, saw his shadow, and predicted another 6 weeks of winter. His prediction has been spot on thus far, with record cold in many areas, rolling blackouts, strain on some of the energy infrastructure in the mid-South, declarations of state of emergency, etc. It’s again been another interesting few weeks. We saw one egregious example where a fairly small establishment in Texas (3 buildings) received a monthly electricity bill for approximately $17,000!
Speaking of Groundhog Day, we feel like we are on a bit of a perpetual treadmill these days concerning the major market drivers. We will take a few minutes to discuss them in this short missive.
The major themes that continue to essentially drive everything – in no particular order they are a) Covid-19, its variants, and the vaccine, b) Inflation, Treasury rates & real yields, c) The Fed, d) Currencies and e) Politics/stimulus, and finally f) Yield spread compression in both IG and high yield. Ultimately all of these moving parts combine to feed into our thesis when following and giving advice to our RIA clientele regarding primarily investment grade fixed income sub-asset class investments.
First, of perhaps primary importance is a COV-19 update. We believe that COV-19, the mutations, and the worldwide response is the biggest driver of markets today. We continue to hear a conflicting story of various mutations affecting new waves of upticks in positive cases. Feb 22nd marked a milestone day with the US declaring the 500,000th COV-19 related death. An article hit home today for us in Atlanta, with Business Insider comparing the death toll to essentially wiping out the equivalent of our entire city population. However, on the flip side, we are getting a lot of positive news about both the administration rate and efficacy rates of the vaccine. The chart below shows both the worldwide dose administration and a breakdown between many major countries:
The United States is encroaching on 20% of the population having received the vaccine. There also seems to be a tailwind behind infrastructure to further enhance vaccine administration in the coming weeks and months as we hopefully approach herd immunity. Reaching this level has major implications on major equity and various rate sensitive asset classes, so we are very closely monitoring the ever-evolving story.
Accompanying the COV-19 information is a discussion about how, in various capacities, this overall stimulus/recovery theme can have important impacts as it pertains to inflation (and ultimately any rate driven market).
If you review the chart below, you can see that we have been running negative real yields for the entire pandemic. Recent pressures have caused the first real uptick in real yields this year:
While the 10-year breakeven rates are still negative, interestingly the 30-year real yields have just recent turned positive:
If you’ve been following our missives, we have been leaning on this inflation hypothesis for some time now. The first reason we believed we might see this was simply due to all the easy stimulus money being handed out. This was likely a necessary evil but has to be “paid for” in some shape or form eventually. Many analysts see rates perhaps gliding higher from here, given further vaccine distribution, and the always rosy hope of business opening and the return to normalcy beginning. There is likely further stimulus coming down the pike based on Biden’s rhetoric.
It appears, however, that there may be a developing food fight between bond bears and The Fed. The Fed, albeit a few recent remarks to the contrary, has indicated that they plan to keep short-term borrowing rates anchored near zero for the next few years, and don’t even mind inflation getting slightly above 2% with that in play. Long term rates are surfing on a currently small steepening wave, thus far 40 bps or so.
Bloomberg highlighted that, in relation to other steepening events, this one has not been noteworthy quite yet. This could lead to a larger wave coming should more stimulus be required and/or the vaccine having widespread distribution and the economy taking off with free money having flowed out of a firehose.
Lastly, we also peek into the commodities markets. We have seen a huge divergence in overall commodity prices and rates, which speaks towards perhaps long rates rising as well. See the chart below:
Our hypothesis is that we will see short/intermediate high-quality bonds remain fairly muted in moves, while we have the potential for significantly more upward mobility in rates on the long end. This could have implications on mortgage refinancing, real estate, etc. Obviously if we take steps backwards with COV-19 cases reemerging and/or the virus not taking hold, rates would be moving back down and a flattening effect occurring.
Now, how does all of this relate to the bond market? In short, net of rates ticking up a bit across the curve and us seeing some steepening driven by upward momentum of rates on the long end, we are maintaining the course of buying primarily high quality short to intermediate term bonds in our ladders. The intermediate term spot seems to have the most value, as shorter-term bonds are being held artificially low by nature of the continued Fed action. Thus, the 3-15 year spot seems to hold the most value here.
Spreads have compressed across almost all fixed income sectors but have been offset by moderately rising rates. We continue to see value in taxable municipals over most corporates, CDs, and Agencies here. Interestingly, munis have remained strong in the face of recent rising Treasury rates. This has led to a dynamic, at least temporarily,
where there could be a case to be made to overweight taxable bonds vs. tax free in the current environment.
The chart below shows AA taxable muni 15-Year yield expectations vs. tax adjusted yields on tax free munis. Even for someone in a moderately high tax bracket, taxable munis are ahead of the game by the largest margin in the last 3 years.
This doesn’t mean we are completely avoiding tax free munis, but for those in moderate tax brackets, you could see taxable bonds implemented where you may have considered tax free munis in the past. Additionally, when coming to us for proposals you may also see us implementing small corporate positions in bonds like CPI-linked notes. We used these long ago and have recently begun to see some value again in them on the bid side. It’s not a huge market but could be used as small positions in portfolios when we can find the bonds.
As always, we are here to help you in any way regarding your portfolios. Don’t hesitate to reach out with any questions, comments or to set up a short discussion.
Until Next Time,
Your PeachCap Fixed Income Team
The above summary of statistics/prices/quotes has been obtained from sources believed to be reliable but is not necessarily complete and cannot be guaranteed. The information and opinions herein are for general information and illustrative use only. This data is not meant to replace Adviser's portfolio management/performance reporting systems. Please consult Adviser performance reports for actual performance data. Such information and opinions are subject to change without notice, are for general information only and are not intended as an offer or solicitation with respect to the purchase or sale of any security or as personalized investment advice. Past performance is no guarantee of future results. Market risk is a consideration if sold prior to maturity. May lose value. Not insured by any federal agency. Subject to availability and price change. Securities offered through PeachCap Securities, Inc., member FINRA, SIPC, MSRB registered.