Observation Deck is a monthly newsletter published by the SVB Asset Management team. In this January 2014 issue our headline commentary, Overthinking the Fed, outlines an overview of events in 2013 that affected the bond market and trading.
Overthinking the Fed
Hiroshi Ikemoto, Fixed Income Trader
There is an old saying in the trading world, “sell on the rumor and buy on the news.” This quote fits perfectly with how the bond market reacted to events in 2013.
From a trader’s perspective, 2013 saw short-term, risk-free rates appreciate by about 0.6 percent from a floor-like base, but nominal averages remained relatively unchanged as the Fed’s Zero Interest Rate Policy (ZIRP) kept the front end well anchored. The benchmark two-year Treasury note stood at 0.25 percent at the beginning of the year and ended at 0.38 percent while averaging 29 bps for the year. The year began with hopes of a “Great Rotation,” in which investors would sell bonds and invest in riskier assets such as equities, which prompted speculation that yields would increase. Despite vastly improved economic fundamentals in the U.S., bonds remained well-bid as the Fed made no indication that it would tighten in the near future. This is not to say that there wasn’t any volatility in the bond market.
Fed Chairman Bernanke set off market schizophrenia in May with his comments about the possibility of slowing asset purchases if the data supports the change. Within seconds of hearing the bank chief’s remarks, market participants exercised selective hearing, leading to a sell-off in the bond and equity markets. While improving, economic and inflationary data was well outside the Fed’s target ranges and was all but ignored by traders as they concluded the Fed would start tapering as early as September. For a three and one-half month period, the two-year Treasury note sold off and yields surpassed 0.50 percent, only to tighten right back to the high-20s before Thanksgiving as September and October Fed meetings came and went without the Fed announcing any tapering.
Not to be outdone by the Fed, our representatives on Capitol Hill took the country’s pristine credit standings to the edge of the cliff as budget and debt ceiling impasses sent yields on Treasury bills soaring to over 70 basis points for bills maturing in October, making U.S. debt obligations the riskiest assets in the portfolio for a two-week period.
This past year saw a record $1.48 trillion of new bond issuance in the U.S., led by Verizon’s eight-tranche $49 billion deal in September. This was the largest corporate bond issuance in history and one of the most successful launches even on the heels of a downgrade of the company by Moody’s and S&P the previous week.
After the over-exuberance of QE eased speculations, bond traders were a bit more cautious and subdued when the Fed finally announced the $10 billion taper in December. Rates slowly drifted up as the two-year note finished the year in the 0.40 percent area, while the ten-year note — which is less affected by the fed funds rate — closed roughly at a three handle, an increase of over 120 basis points. Both benchmarks traded on very light volume as most participants took the last two weeks off for the holidays. In hindsight, one can say that the market either overreacted or underreacted or simply got it wrong. But these swings in the market provide alpha that we, as traders and investors, try to capture.
Paula Solanes, Portfolio Manager
The Fed ended the suspense as it announced the start of tapering, or slowing of asset purchases, starting in January on the heels of more positive economic data and stronger outlook.
The U.S. economy added 203K jobs in November, making the average monthly pace about 190K year to date. The unemployment rate dropped to 7 percent, a five year low and the biggest drop in over a year. November’s drop in the unemployment rate was supported by strong job growth rather than simply an all-time low in the labor force participation rate.
The final revision to third quarter GDP surprised economists coming in at 4.1 percent, versus the prior estimate of 3.6 percent. This was the highest GDP number in almost 2 years. In addition, this last revision showed that growth was propelled not only by an increase in inventories, but also by an increase in consumer spending on services and business investment. Business investment included an increase of 5.8 percent in intellectual property, up from an initial estimate of 1.7 percent.
As the end of the holiday season approached, personal spending increased by 0.5 percent in November with spending on durable goods increasing 1.9 percent led by vehicle sales. Retails sales were at a 5 month high with a 0.7 percent gain.
On the housing front, purchases of previously owned homes dropped 4.3 percent to an annualized 4.9 million due to rising prices and borrowing costs along with limited inventory.
Finally, almost as a side-note, inflation continues to be benign with core prices, which exclude food and fuel, increasing only 0.1 percent in November and 1.1 percent year over year.
Timothy Lee, Senior Credit Risk & Research Officer
Current credit performance from securities backed by auto loan and lease payments has been strong, with delinquencies and loss protection levels to remain solid over the medium term. According to Moody’s data, from November 2013, there were zero downgrades of auto loan asset-backed securities (ABS) in the Aaa and Aa rating category over the previous 12 months, with only one downgrade by one level in each of the A, Baa and B categories.
The stable ratings and the absence of any defaults reflect low delinquency levels and low net losses. As of October 2013, prime auto loans backing auto ABS that were delinquent by 60 days or more amounted to 0.41 percent, according to Moody’s. Comparatively, loan delinquency over the past 12 years peaked at 0.88. The depressed levels of delinquencies have helped maintain losses near the lowest levels over the past 12 years. At 0.52 percent as of October 2013, the three-month average net loss experience is roughly at least six times lower than the approximate three percent average minimum loss protection afforded by credit enhancement in recent prime auto ABS transactions.
The muted loss levels on auto loans have been buttressed by buoyant used vehicle auto prices, which partly dis-incentivizes defaults and increases recovery values. Steady used vehicle car values have also supported stellar credit performance for auto lease ABS, where no downgrades occurred over the past 12 months through September 2013, according to Moody’s.
While used vehicle prices are anticipated to soften over medium term and exceptional loan underwriting standards will fade, delinquency levels may rise marginally but remain subdued, and loss levels will continue to be well below the credit protection levels inherent in auto ABS transactions.
Eric Souza, Senior Portfolio Manager
Fixed income yields rose in December on continued positive economic data and the much anticipated tapering announcement by the FOMC. The two-year Treasury started the month at 0.28 percent and rose to 0.35 percent on the day of the FOMC meeting. The 10-year yield rose 14 basis points to 2.89 percent. However, Treasury yields inside of one year have actually rallied with 6 month Treasury yields ratcheting down a couple basis points in December. Corporate bonds have outperformed in December despite yields rising as credit spreads to Treasuries have tightened. Moreover, corporate bonds are the only main sector of the Aggregate Index in positive territory for the month of December. Corporate bond issuance is over $50 billion for the month led by both the industrial and finance sectors. The demand for short corporate bonds should continue into 2014 as many market participants are shifting their focus to the short end of the curve in anticipation of a rise in yields.
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