SVB Asset Management's monthly Observation Deck newsletter covers current topics on portfolio management, credit considerations and market events that influence investment strategy.
Paula Solanes, Portfolio Manager
In the last 12 months, more and more clients have been asking, what are your other clients doing? The financial crisis has passed; the U.S. economy is on more stable footing; and the global economy is on a steady path. However, interest rates in the short end of the yield curve are still anchored very low due to continued accommodative monetary policy. The more stable economic environment coupled with low yields has investors moving beyond money market funds, treasuries and agencies to a combination that includes corporates and aims to be more strategic. Depending on their own cash needs, clients are adopting one of the following strategies: a buy and hold approach, asset liability matching, or total return(TR). For clients with clear visibility of their cash flows, a total return approach could potentially prove advantageous.
Compared to a buy and hold strategy, a TR strategy takes advantage of regular coupon payments for income but also has the advantage of capitalizing on price appreciation. If a bond is held to maturity, the only advantage becomes the coupon payments, but none of the possible price increases over the holding period are realized. However, if a bond appreciates in value due to interest rate decreases, or in the case of a corporate bond due to an improvement in the credit standing of the issuer, a TR portfolio will be able to capitalize on the price movement. Investors should still have income as a goal, but why not take advantage of price appreciation opportunities? Strategically combining income and price appreciation provides flexibility and diversification along with the potential for enhanced return. A TR approach provides flexibility by opportunistically rebalancing the portfolio. In addition, a TR approach provides diversification because it allows portfolios to capitalize on price appreciation and thereby become less income dependent. Without the need to rely on yield portfolios, the investor can diversify the portfolio into different security types.
In order to implement a TR strategy a manager formulates opinions on the economy, considers the direction of interest rates and the credit landscape. Given the recent developments in the economy one simple trade has been to buy and sell two-year and three-year treasuries, which have been trending upwards within a range. The graph below shows an upward trend to both the two-year and three-year yield in the last 12 months. At various points, there have been buying opportunities when the curve sells off. From May 2013 through September 2013, Bernanke’s talk of tapering introduced quite a bit of volatility. Both the two-year and the three-year peaked due to uncertainty regarding tapering, until finally it was taken off the table in September and treasuries started to climb again.
Since then there have been other instances of spikes along the yield curve, such as last month when Fed chair Janet Yellen mentioned in a press conference that the fed funds rate could be increased as early as midway through 2014. Once the FOMC minutes were released, they revealed that Fed members did not discuss when rates would rise, causing treasuries to rally. These scenarios cause price volatility, which create opportunities to capitalize on price appreciation.
Opportunities will arise to capitalize on price fluctuations as the economic landscape continues to stabilize and speculation around when interest rates will rise triggers volatility in the yield curve. As these instances occur, it will be important to consider projected cash flows and potential opportunities.
Credit Vista: A Horse of a Different Color
Kyle Balough, Credit Research Analyst
The regulated utilities industry does not function like a typical industrial sector. Governments must ensure access to reasonably priced power at minimal environmental costs, yet regulated utility companies are not public. These private entities are charged with the task of generating and supplying power to the public with difficult standards imposed by states and the federal government.
Utility companies spend heavily on capital expenditure. These costs can be classified as maintenance or expansionary, and when combined generally result in negative free cash flow. Maintenance capital expenditure pertains to downed lines and input costs, while expansionary capital expenditure is the upgrading of equipment and new plants. Without expansionary capital expenditure most utility companies would be free cash flow positive. While expansion requires additional debt, these projects are granted a rate of return that supports debt repayment. The underlying issue is that utility companies are actually being forced to continually expand by rate granting regulators (i.e. state public service commissions) in order to satisfy investor required returns.
Regulators limit what is charged to consumers through rate cases. Think of rate cases as an application to charge customers cost pass-throughs. Utility companies are granted a return on new projects by increases to customer rates. Depending on the regulator, these rate cases are structured differently and ROEs vary based upon a number of factors. One example would be the San Bruno, CA gas main explosion and the following rate case for PG&E. If PG&E were not granted cost recovery and supported by the state, PG&E could have been crippled by the incident. The rate case system is a mechanism that ensures a utility will always generate enough cash to pay back investors.
Rate case structure, conservative capital expenditures and a positive relationship with regulators are extremely important factors for a successful utility. SVB actively searches for utility companies with accommodative regulatory environments and conservative management practices for consideration as an addition to our approved list.
Economic Vista: Weathered the Storm
Jose Sevilla, Portfolio Manager
In a move that met market expectations, the Federal Reserve left the fed funds target rate unchanged and trimmed $10 billion from its $55 billion monthly asset-purchasing program. The Fed is now purchasing $45 billion in US Treasury and mortgage-backed securities each month to help make broader financial conditions more accommodative. The fed policymakers did not reflect substantial concerns and in fact reflected consensus that the recent economic slowdown will be short-lived and expect growth to accelerate.
U.S. economic growth stalled in the first quarter as the harsh winter weather that blanketed much of the country slowed the pace of business investment and home construction. The stall occurred even as consumer spending rose due to an increase in spending related to the Affordable Care Act. GDP grew at a 0.1 percent annualized rate from January through March, compared with a 2.6 percent gain in the prior quarter. Economists surveyed believe that the weather accounted for a reduction of as much as 1.4 percent from GDP growth. Trade also took a bite out of the economy, as exports fell 7.6 percent in the first quarter.
U.S. retail sales rose 1.1 percent with 10 of 13 major categories showing increases, led by a 3.1 percent in auto sales and a 1 percent gain in building materials and retail. Excluding autos, sales increased 0.7 percent, which was stronger than expected.
New home sales for March surprisingly fell 14.5 percent, the lowest level in eight months and could signal that the recent softness is more than seasonal and weather related. Higher home prices and higher mortgage rates have dampened affordability. This report followed March existing home sales which fell for the third straight month.
Non-farm payrolls rose by 192,000 in March. The labor participation rate rose slightly to 63.2 percent from 63 percent. The U6 rate, which accounts for the underemployed and a closely watched number by Yellen, ticked up to 12.7 percent and is still above the long-term average of 10 percent. The unemployment rate held steady at 6.7 percent, as the household survey showed a 476K increase in employment and a 27K increase in unemployment, causing a slight in increase in the participation rate which is at the highest readings in seven months. The Fed agreed that the labor market continues to improve on balance, however, pointing out factors such as elevated levels of long-term unemployment and part-time workers as evidence that there might be considerably more labor market slack than the unemployment rate alone suggests.
Both the headline and core CPI printed a 0.2 percent increases in March. This lifted the year-over-year rate in the headline to 1.5 percent from 1.1 percent while core CPI moved up to 1.7 percent from 1.6 percent, where it has been range-bound since last April. Despite the slight rise in prices, inflation remains subdued. The personal consumption expenditures price index, the Fed’s preferred inflation measure, rose 0.9 percent in the year through February, although it is still more than a percentage point below the central bank’s target (2.0 percent).
Trading Vista: Risk On/Risk Off
Eric Souza, Senior Portfolio Manager
April was a volatile month for both the bond and stock markets. The volatility kicked off with the monthly payroll report, which was released on the first Friday in April. The payroll report was overall positive resulting in initial rallies in both fixed income and equities, although this was short lived. The on-the-run two-year treasury note rallied three basis points on the open to 0.43 percent and closed the day at 0.41 percent. It was a different story for the stock market with equities initially rallying after the payroll report but fizzling during the day and spread to the broader markets such as the S&P 500.
Next, we had the release of the FOMC minutes which solidified the Fed’s dovish bias. The markets interpreted the Fed’s silence on the timing of quantitative easing (QE) and rate hikes as market-friendly. On this release, once again the bond market rallied but equities sold off. The two-year treasury yield fell below 0.40 percent to close at 0.35 percent. A positive retail sales report in mid-April helped curtail the recent equity “risk-off” movement, although the bond market sold off.
Companies that reported positive financial results for the first quarter, combined with Fed chair Yellen’s dovish speech at the New York Economic Club, further fueled market optimism. Market participants honed in on Yellen’s back peddling of previous comments regarding possible rate hits ‘six months’ after the end of QE. Heading into month-end the bond market continued its sell off while the stock market holding on to the rally.
Due to recent sell-offs in treasuries, corporate bonds and automobile asset-backed securities outperformed comparable treasuries in April. Spreads on corporate bonds rallied and secondary corporate bond inventory continue to be met with strong demand and additional pent-up demand. Interestingly, we are near the tightest spreads in the past 10 years. For example, the spread for the one- to three-year Barclays Credit Index is approximately +49 bps—only 10 bps from the 10 year record dating back to December 2006. Although spreads are at tight levels, they will still remain well bid due to strong supply/demand factors and offer much better yield and income when compared to similar maturity treasuries.0414-0052
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.