Looking Forward Assuming Vaccine Efficacy

December 14, 2020 | Cameron Parkhurst

Happy Holidays, Everyone!

Even though this has been a strange, trying year for us all, it is time to celebrate the season, whether in person or digitally. Our team wishes all our friends, family, and clients a happy and healthy holiday season and a Happy New Year!

The daily news regarding a COV-19 vaccine is in flux, but it certainly seems like there are significant tailwinds towards vaccine distribution. There will be at least a handful of viable options as soon as New Year’s through Q2 2021 and beyond. At least three companies are claiming efficacy just under 100%, and the Atlanta Journal-Constitution reported that our current Vice President, Mike Pence, stated that a vaccine approval could be “a week and a half away” on December 4th. With this news, the equity markets have again accelerated. There is also news out about drugs effectively preventing the spread should an individual contract the virus. There is simply a lot of positive news out there on this front currently.

But which market is getting this right…Equities or Bonds? And what are implications for the markets we deal in daily for our RIA clients? Historically speaking, the bond market has had the nod. To evaluate this completely, we are on a course to look at implications of both a vaccine/return to normalcy, and the impacts of essentially free flowing money toward future inflation.

Since March…and the perceived beginning of the COV-19 outbreak (likely was earlier than that), let’s see what Treasuries have done:

In early spring of this year, we had an inverted yield curve. At that time, there was some talk of recession, as we were “long in the tooth” historically speaking. We were

staring at in inverted yield curve, which is historically an indicator of a recessionary environment. Since then, with significant Fed and governmental intervention, short term Treasury rates have plunged from around 1.5% to almost zero.

We have seen a COV-19 related tidal wave of unemployment, changes in where we work, many business closings, significant subsidies given, and continued stress to many areas of the municipal landscape. However, with the very quick market recovery, discussions of recession by equity analysts vanished.

There has certainly been a flight to safety regarding fixed income exposure (especially in muni land – look at yield differences between names like transportation related bonds and essential services). With the FOMC indicating that rates may be held low through even 2024, we may have an anchor on at least short-term Treasury rates for a while. This, however, seems like a very long-term prognostication for most analysts and for us. Our feeling is that, assuming a vaccine/recovery, the Fed may back peddle on this long-term forecast, and may be forced to raise rates well before 2024.

So, what if a vaccine has efficacy? What if we return to normal? First, that would open up our playbook on bond purchases? We have been avoiding many COV-19 impacted areas, such as ports/airports, smaller colleges, transportation sectors, hotel occupancy bonds, smaller municipalities that rely on tourism, stadiums/convention centers, etc. In the last commentary, we held a short discussion of airport ridership, and were obviously cautious. In the last couple of weeks, however, airport bonds have appreciated and narrowed significantly:

This comes from positive news both on the COV-19 vaccine front, as well as news regarding the approval for the Boeing 737-Max to fly again. Ryanair put in an order, following the news here, that the 737-Max will be its primary aircraft for the future, and contracted 75 new planes to be built (210+ total). This is air under Boeing’s wings, and certainly shows that at least some airlines think that we will be seeing ridership increases soon. If this type of news on both fronts continues, it is clearly positive for the economy, generally speaking.

Our feelings regarding this are cautious, but positive. During the dark period of the Covid-19 debacle we simply avoided airport bonds in totality. Ridership sank to a low of 9% of normal and it seemed airports and airliners were doomed. We have not seen a significant rebound in ridership but believe that airlines and airports have begun to give the public more faith that we can travel safely, vaccine or not. Ridership was up to around 35% of normal during the Thanksgiving holiday, and with a vaccine, we believe that we could see ridership grow substantially. Will we ever get back to 100% of 2019 levels? Who knows? Some business travel, which is really the high margin ticket for many airlines, may not ever return. However, sustaining public air travel (and general commerce) for the country is imperative. With ridership increasing, and with a vaccine on our doorstep, we are moving to begin the buying of at least the major hub airports as part of our portfolio. We believe that the risk/reward tradeoff is favorable there. If we can find these bonds with muni insurance, all the better inside of a well-diversified portfolio also including GOs and essential service revenue bonds.

One major question that remains, inside of a thesis of a vaccine/return to normalcy, however, is regarding inflation. From a recent Bloomberg article:

“Writing for Bloomberg Opinion, former New York Fed President Bill Dudley, argued that inflation may come back faster than most people expect. First, there’s the base-effect. Mechanically, the year-on-year headline inflation will be higher, because of low prices in 2020. Secondly, economic normalization will give companies more pricing power as demand recovers, at a time when supply is likely to be constrained. Then, the fiscal stimulus is likely to come when the Fed is determined to let inflation run hot.”

This is something that we discuss every week. With all the free money that has been floating around, we may see an inflationary scenario unfold in the coming years. No one can be certain of how meaningful this might be, but in an environment where we have new issue munis/taxable munis coming out with extremely low coupons, it needs to be on the radar. Many institutional managers are being forced to buy these new

issues at 1% -1.75% coupons, and these bonds will potentially have significantly more volatility than higher coupons if rates rise. We acknowledged and discussed this in some detail last month. Check out charts below:

The chart above is a dated piece from Schwab. However, it clearly shows, that the bulk of fixed income returns for your clients have been from coupon income and not from price appreciation. We have preached this for years. This is one of the primary reasons, in addition to the odd-lot advantage, why we focus on the secondary market and bid bonds for our Advisor clients. In a market where new issues are coming out at par with 1.5-2% coupons, we can grab 4%+ coupons in the secondary market at premiums, but with higher yield and lower duration/interest rate sensitivity. With this thought in mind, let’s take a trip down memory lane to our econ 201 course in college…

Please check out the very simple chart below which shows price movement of a low coupon vs. high coupon bond during a rising rate scenario…otherwise known as convexity:

One of our main goals is to be experts in our, at times, very boring field…but at the same time be able to communicate technical thoughts on a level field that an RIA’s clients will understand. Convexity is one of these discussion topics that often goes above the traditional thinking of the individual fixed income investor. With this, let’s take an example:

Bond 1 has AA credit quality and a maturity of 12/1/30. Its coupon is 5%. It will be purchased at a premium as it is paying more annual coupon. Bond 2 has the same

name, same AA credit quality, a maturity of 12/1/30 and has a 1.25% coupon. Let’s just say that both bonds are purchased, in this example, at 1.25% yield to maturity.

Now, let hypothesize that interest rates rise to 2.5% over the next year. Which comparable bond is less volatile in this environment? Answer: the 5% coupon. You have much higher coupon income to offset the rise in interest rates. This is the definition of convexity:

“Convexity is a function of the bond price, YTM (Yield to maturity), Time to maturity, and the sum of the cash flows. The number of coupon flows (cash flows) change the duration and hence the convexity of the bond. The duration of a zero bond is equal to its time to maturity, but as there still exists a convex relationship between its price and yield, zero-coupon bonds have the highest convexity and its prices most sensitive to changes in yield.

A bond with a higher convexity has a larger price change when the interest rate drops than a bond with lower convexity. Hence when two similar bonds are evaluated for investment with similar yield and duration, the one with higher convexity is preferred in stable or falling interest rate scenarios as price change is larger. In a rising interest rate scenario, a lower convexity (higher coupon) would be better as the price loss for an increase in interest rates would be smaller.”

Like we have said, no one has the crystal ball to objectively say how high rates could go should we see a vaccine, normalcy, and employment possibilities gaining traction. We don’t believe that we will see runaway inflation like investors saw decades ago, but rates moving up 0.5%-1% is certainly in the cards at some point. During that environment, if we get it, our higher coupon bonds will typically prove to be a much better buffer against interest rate movement when compared to the new issues and lower coupon bonds out there.

With this, we are staying the course on our strategy of buying high quality munis and taxable munis in the secondary market, focusing on odd lots and using the bid side to add incremental yield to portfolios. We continue to see better spreads for the risk taken in taxable munis vs. corporates, and munis stick out as attractive in most

instances for higher tax bracket clients. The playbook of our focused sub-asset class securities will likely open up a bit as we see the efficacy of the vaccine and its impact

on markets, but we will remain cautious and continue to perform systematic due diligence on held CUSIPs for our clients.This will allow us to continue to be an excellent resource to our Advisors who rely on us to create business efficiencies and value to their practice.

Until Next Time,

Your PeachCap Fixed Income Team

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