Silicon Valley Bank
SVB Asset Management’s monthly Observation Deck newsletter covers current topics on portfolio management, credit considerations and market events that influence investment strategy.
Revaluating the Credit Markets
Jose Sevilla, Senior Portfolio Manager
Corporate bond returns have had an extraordinary run. With rates near zero, the markets have forced the hand of yield-hungry investors. So far the bet has paid off as Investment Grade (IG) Corporates have returned 4 percent annually on a total return basis, since 2009, according to BofA/Merrill Lynch 1–3 year AAA-A U.S Corporate Index.
Meanwhile during the same period, the IG spreads over U.S. Treasuries have rallied, which means less yield for investors. (Figure1) Investors now question if the recent returns can be repeated and if credit premiums should be reconsidered. In addition, there is the uncertainty about the Fed’s next interest rate hike. However, most investors would agree that interest rates, which have been persistently low for quite some time, are poised to rise in the near future.
Low interest rates have successfully propped up asset prices, bolstered consumption, and increased the demand for credit—ultimately lifting the general economy. These historically low rates along with strong investor appetite for credit have depressed U.S. corporate bond yields. The feedback loop continues as corporations, many of which have already strong cash positions, increase their debt outstanding with new bond issuances at cheap funding levels. Specifically, U.S. IG corporate bond issuance through July 2014 has totaled $603 billion. That is an increase of 12 percent compared to the same period in 2013.
Furthermore, despite recent geopolitical events and uncertainty regarding monetary policy, investors continue to seek out corporate bonds. The net inflows into U.S. High Grade Bond funds through June 2014 were $12.0 billion, compared to $10.4 billion of inflows in May. Breaking it down further, the $12.0 billion of inflows consists of short-term funds ($1.7 billion), intermediate, long-term, and total return funds ($10.3 billion in total), according to EPFR.
Another event causing spreads to tighten, dealer inventories of corporate bonds have declined significantly due to increased regulations. Banking regulations such as the Volcker Rule and Basel III require banks and broker/dealers to maintain certain levels of increased capital and liquidity. After the crisis, dealer inventories have shrunk, while the size of the corporate bond market grew. (Figure 2) The reduction in dealer liquidity could negatively impact bond valuations as big broker-dealers take a less active role as intermediaries.
While all of this is true and some people are calling it a “bubble,” the “bubble” talk is a bit overstated. The term “bubble” is often associated with elevated price increases followed by significant losses. A case for a bond “bubble” rests on the assumption markets are over-bought and that interest rates will rapidly rise in the near term, which would cause adverse mark to market issues. Economic conditions and the Fed’s timing, pace, and magnitude of future rate hikes is critical to how these risks could play out. The Fed has reiterated that it is in no rush to begin normalizing interest rates, despite the recent rise in inflation and the pace of employment growth. The Fed will likely take measured steps regarding tightening monetary policy, doing so will allow it to evaluate the effect on the economy and markets. Therefore, the concern for potential bond bubbles should dissipate over time as investors adjust portfolio strategies to the current market conditions.
By implementing specific portfolio strategies, we can certainly mitigate some of the risks of the bond bubble. For example, we can invest in short-term bonds with laddered maturity dates. The trade-off to this approach is to accept lower yields in exchange for a potentially small drop in market values. Exploiting short maturities could also position a portfolio’s principal back sooner, which allows us to reinvest in response to climbing interest rates. We will also limit exposures by investing in smaller bond positions in high-beta names, while taking advantage of higher quality, lower volatility names and sectors. We also consider investing in floating-rate securities as another way to take advantage of a rising rate environment as its yield adjusts to higher interest rates.
Ultimately, the situation might not be as bad as some may fear as there can be ways to calm the so-called bubble talk.
Credit Vista: SEC Money Fund Reform
Kyle Balough, Credit Research Analyst
The wait for money market mutual fund reform is over. On Wednesday, July 23, 2014, The Securities and Exchange Commission (SEC) voted 3-2 to approve money market fund reforms which were originally proposed in June 2013. The SEC approved the combined implementation of structural reform along with several disclosures and diversification requirements.
In two years’ time from the date these rules are published with the Federal Register, Prime and Municipal Institutional MMFs will require investors purchase and redeem shares at a market based net asset value (MNAV) per share, priced to the nearest hundredth of a penny. Currently, prime institutional and municipal investors can purchase and redeem shares based upon shares priced to the nearest penny. Retail funds, defined as those catering to “natural persons,” along with government funds, defined as those investing at least 99.5 percent in government securities, would have the option to adopt MNAV but are not required to do so.
In addition to MNAV, all money funds including retail and government funds, at the discretion of the fund board of directors can halt investors from redeeming funds and/or charge a liquidity fee if weekly liquidity falls below the 30 percent regulatory minimum. Both structural reform features aim to better equip money market funds to address run risks (large redemptions from multiple investors on money funds that can leave remaining investors with devalued and long-dated securities) while preserving the benefits of money market funds. MNAV also adds a level of transparency to investors regarding the value in underlying fund assets.
Along with these structural changes, the SEC will require new reporting standards, enhanced stress testing and diversification requirements that should improve the integrity of the money fund industry to such fluctuations in value.
SVB Asset Management views the increased level of transparency as positive for investors and will monitor the implementation of these reforms and their effect on the industry. For more information on MMF reform please visit
Economic Vista: Half Empty/Half Full
Eric Souza, Senior Portfolio Manager
Gains in consumer spending and business investments led economic expansion in the second quarter. After shrinking 2.1 percent in the first quarter, gross domestic product rose at a 4.0 percent annualized rate indicating prior quarter slump was an anomaly. Additionally, when the Fed met it reiterated its current monetary policy of targeting the fed funds rate at 0–0.25 percent and continued its monthly bond purchases reduction by $10 billion. The Fed will now purchase $10 billion of agency mortgage-backed securities and $15 billion of longer-term Treasuries.
While the Fed is encouraged with the decrease in the unemployment rate it did indicate a “range of labor market indicators suggests that there remains significant underutilization of labor resources.” Nonetheless, the employment report came in better than expected at 288,000 vs expectations of 215,000 and the prior month was revised upward to 224,000 from 217,000. Both the three- and six- month averages are now above 200,000 (272K and 231K respectively). The unemployment rate fell to 6.1 percent which is the lowest level since September 2008. The good news on the drop in unemployment rate was that it fell due to an increase in jobs and not because of the labor force participation rate falling. The participation rate held steady at 62.3 percent which is still the lowest level since 1978. Although an overall positive report, average hourly earnings rose only 0.2 percent in June and 2.0 percent Y/Y which is not helping the consumer keep up with inflation.
Inflation readings have been rising with the CPI index increasing 0.3 percent which is currently up 2.1 percent for the year. The Fed’s favorite inflation gauge, the Personal Consumption Expenditures Index, rose to 1.8 percent from 1.6 percent previously while the core reading rose to 1.5 percent from 1.4 percent previously. For the majority of 2013 and in the first quarter of 2014, the PCE averaged 1.2 percent. In minutes from the recent FOMC meeting, the Fed overall seems mixed on the outlook for inflation. The Fed sees diminished risk of inflation running below its 2.0 percent target with the recent pick-up in inflationary readings.
Trading Vista: Range-bound for Now?
Renuka Kumar, CFA, Portfolio Manager
We continued to see the short-end of the curve trade in a range-bound state throughout the month, but yields did inch up a bit higher in light of better economic data. The three-year benchmark note ranged from 88 to 102 basis points, averaging 96 basis points in July vs. 80 basis points in June. The two-year benchmark note ranged from 45 to 56 basis points, averaging 49 basis points vs 44 basis points the prior month. A strong payroll report at the beginning of the month led rates higher but, while we saw a flight to safety mid-month due to geopolitical concerns, the reaction was short-lived and yields climbed back up in the latter part of the month.
Corporate bond spreads remained tight given the high demand in this space; however on a relative basis, the corporate bond sector continues to be attractive on a risk-adjusted basis. Agency bonds and discount notes have also provided some value over Treasuries at spreads between 2–4 basis points over similar maturing securities.
Looking ahead, the markets will be focused on incoming economic data as the Fed reiterates that monetary policy remains data-dependent. With tapering on track to end in October, naturally, the question now is when and how fast rates will rise.
SVB Asset Management, a registered investment advisor, is a non-bank affiliate of Silicon Valley Bank and member of SVB Financial Group. Products offered by SVB Asset Management are not FDIC insured, are not deposits or other obligations of Silicon Valley Bank, and may lose value. This material, including without limitation to the statistical information herein, is provided for informational purposes only. The material is based in part on information from third-party sources that we believe to be reliable, but which have not been independently verified by us and for this reason we do not represent that the information is accurate or complete. The information should not be viewed as tax, investment, legal or other advice nor is it to be relied on in making an investment or other decision. You should obtain relevant and specific professional advice before making any investment decision. Nothing relating to the material should be construed as a solicitation, offer or recommendation to acquire or dispose of any investment or to engage in any other transaction.