January 14, 2021Institutional Investment Management

“An End in Sight”


The first doses of the vaccine were administered in late December.  Since there will be at least two companies with approved vaccines, and likely more than three, the most vulnerable should be protected by the end of the first quarter.  This should result in fewer fatalities and falling positivity rates.  Economic activity will increase rapidly as 12 months of isolation begins to wind down.  Schools should reopen, sports may allow more fans into arenas and stadiums, and restaurants may be allowed to reopen.  There may truly be an end in sight by the end of March.

GDP for the 4th quarter is estimated to be close to 8% according to the GDPNOW forecast provided by the Federal Reserve Bank of Atlanta.  This comes on the heels of a 33% increase in GDP in the 2nd quarter.  Stimulus checks are being mailed in late December and additional help will be discussed in the coming weeks. We expect the unemployment rate will fall sharply by midyear.  Housing remains very robust as a desire to leave the city combined with very low mortgage rates led to an increase in demand for single family homes.  The Purchasing Manager’s Index (PMI) remains at expansionary levels.  Interest rates are extremely low.  Credit spreads for investment grade debt are currently near all-time lows and are at the same level as where we started the year.  It seems likely economic activity in 2021 will be quite strong given the momentum we have and a very accommodative Federal Reserve.

Before we discuss strategy ideas for the 1st quarter, let us recap what happened in the bond market and the equity market last quarter.  Short-term interest rates barely changed during the 4th quarter but the 10-year T-note yield increased 25 basis points and the yield on long bond increased 22 basis points.  The S&P 500 advanced 12% in the 4th quarter, the NASDAQ advanced 16%, and the small cap index increased 31%.  The Nasdaq will likely have a 40%+ return for 2020 which is slightly higher than the performance of this index for 2019.  Maybe the longer end of the yield curve is expecting slightly higher inflation? 

We have frequently discussed non-agency, mortgage-backed securities.  While prepayment speeds can be as high as 60 CPR, there are bonds whose prepayment speed slows quickly resulting in an attractive profile.  Here is a current example.  Sequoia issued SEMT 2018-2 A7 in early 2018 and the average mortgage rate to the homeowner is 4.00%.  This seasoning has resulted in the current 20% credit support versus 15% when it was issued.  Credit support increases over time as the security prepays but does not suffer losses.  It has a AAA credit rating and losses to date have been zero.  Using the 3-month prepayment speed of 60 CPR we get a yield of 1.31% which is a 120-basis point spread to the 1.18 year average life.  If the prepayment speed slows to 40 CPR, the yield increases to 2.34% to a 2.26 year average life.  We see excellent value in this type of security (and the issue referenced was not a specific buy or sell recommendation).

Agency-backed, mortgaged-backed securities (MBS) are a staple for many institutional investors.  Higher coupon MBS are trading at very high premiums.  In addition, prepayment speeds have been very high resulting in yields less than 50 basis points with the possibility of a yield close to zero.  We analyzed a 15- year Freddie Mac pool with a 2.0% coupon.  The rate to the homeowner was 2.70%.  Using the current prepayment speed of 20 CPR the MBS has a 0.60% yield to a 3.30-year life.  A reduction in the prepayment speed to 12 CPR results in a 0.95% yield to a 4.50-year life.  We don’t find this overly compelling and prefer to sit on the sidelines for a month or two and see if rates continue to rise.  

"Agency-backed, mortgaged-backed securities are a staple for many institutional investors."

Municipals had been a very good option for tax-exempt investors earlier this year.  A 10-year bank qualified issue backed by the Minnesota school district credit enhancement program provided the investor with a tax-exempt yield of 1.95% last May.  Six months later, this same bond had a yield of 1.15%.  Taxable municipals reacted in a similar manner showing large rate declines at a time when longer-term Treasury yields were rising.  The combination of what is usually low levels of issuance in the first three months of the year (the January Effect) along with an expectation of higher tax rates should be supportive of muni bond prices, keeping yields low.  As an asset class that typically lags the Treasury market’s moves, we anticipate the current unattractive yield level will persist until Treasury yields move substantially higher.  At which time, and once investors see their values decline, funds may flow out of munis and yields should close the gap with the Treasury market.  If history is a guide, yields may get too high as compared to like-term Treasuries.

Our goal is to provide readers with timely recommendations for their portfolio.  As we surveyed the fixed-income markets we found very few compelling ideas.  Interest rates near zero combined with narrow yield spreads results in fewer strategies than usual.  Sometimes the best strategy is to be patient and wait for a better environment.  Markets are constantly changing.  We are confident there will be a more favorable climate in the coming months.  Opportunity costs are low, which favors patience.

Interest Rate Outlook - Eat, Drink, and Be Merry

2021 offers the prospects of the pandemic subsiding and “certainty” regarding the political direction of the Unites States.  A change in the direction of the political pendulum will occur, but the narrow majorities in both houses of Congress may temper the magnitude of the changes.  Alternatively, the handful of moderate politicians may be showered with so many political opportunities, or “wins” for their constituents, that it will result in increased spending so the House, the Senate, and the President can finally “get things done.” If we look at the various plans that were mentioned on the campaign trail, the “things” will involve infrastructure spending, additional stimulus dollars for some individuals, possible debt relief programs, the promise of increased healthcare services (including a single-payer option – “Biden-care”), and money to benefit schools, higher education institutions, challenged municipalities, help for healthcare systems, and many other compelling causes such as environmental justice (Green New Deal). 

To raise the funds to partially pay for the new efforts we will need to increase taxes in many forms.  As a presidential candidate, Joe Biden indicated income taxes would increase for those making more than $400,000, as well as a hike in the corporate income tax from 21% to 28%.  He also advocated for taxing capital gains at ordinary income rates for those making more than $1 million a year.  There are additional tax increases but the “heavy lifting” from a revenue generation standpoint would be shouldered by those three increases according to the Tax Foundation.  Those increases should produce roughly $200 billion a year over the next decade.  In total, the Tax Foundation estimates the entire tax plan would raise $3.3 trillion over the next decade.  Their conclusion was that the cumulative impact of the taxes would be to “shrink the long-run size of the U.S. economy by 1.62% due to higher marginal tax rates on labor and capital.”  As some people interpret the Tax Foundation to be critical of increasing taxes, it is worth looking at the Moody’s analysis, often cited by the Biden campaign, of the various political outcomes of the recent elections.  Under a “blue sweep” scenario, Moody’s surmises that over the next decade, the Biden plans would add half of a percent to GDP as compared to their Trump scenario, and would come at the expense of annual deficits in the range of $2 trillion to $3 trillion and a debt-to-GDP ratio that increases from the 100% measure at the start of 2020, to roughly 130% in 2030 (in full disclosure, the current policy scenario - Trump with a divided Congress – Moody’s estimates the ratio would grow to 125% in 2030).  Since the U.S. is looking at a 2020 deficit of nearly $4 trillion, on a $20 trillion economy, we may hit a ratio of 120% to 130% before the end of the pandemic.   According to the St. Louis Federal Reserve, that measure of indebtedness was as low as 64% in 2008.  A change of this magnitude in a slow-growth world, and with alternative “reserve currencies” becoming more probable, suggest to us the future consequences will be significant.

Beyond simple dollars and cents, there will be a pendulum swing in other areas.  Specifically, the Federal Reserve and Treasury focus may shift from a Wall Street to a Main Street and there is apparently an appetite among prominent democrats for an increased regulatory environment.  Since regulation often benefits larger entities (as a barrier to entry for small competitors), it will be interesting to see how this plays out.  Greater levels of regulation often increase the cost of goods and service delivery.  Small employers, without easy access to the capital markets, experienced great challenges during the pandemic.  Yelp, the online review entity, says that since March, 164,000 businesses on their website have closed, nearly 100,000 of them permanently.  The incoming administration should be focused on job creation.  According to the Small Business Administration, small businesses account for 64% of net new private sector jobs and make up 49.2% of private sector employment.  Burdensome regulation could act counter to what should be a broadly shared goal.  

"The Federal Reserve and Treasury focus may shift from a Wall Street to a Main Street and there is apparently an appetite among prominent democrats for an increased regulatory environment."

President-Elect Biden has named former Federal Reserve Chair, Janet Yellen, as his choice for Treasury Secretary.  The market seems to interpret this favorably and clearly, she has a strong background in public service and academia.  She is a champion for what she’s called “extraordinary fiscal support” to get through this pandemic and she has said deficit spending is affordable given the current extraordinarily low interest rates.  Janet Yellen has generally been supportive of tighter financial regulation.  Again, if a goal of the President-Elect is access to credit and fuller employment, it seems like it would be a questionable move to hike up regulation on banks when the economy is attempting to recover.  Yellen’s record indicates that she will target the “shadow banking” industry (investment banks that are outside of the Feds purview) and in specific, “leveraged lending”, which is lending to businesses that are already highly indebted.  The concern seems to be that job losses could result if the borrowers start defaulting.  If the businesses close because they don’t have access to capital from willing lenders, wouldn’t the result be much the same? As Treasury Secretary, Yellen would be instrumental in managing trade policy.  In the past, Yellen has been in favor of liberalizing trade policy and has indicated that determining when a country is manipulating a currency is “difficult and treacherous.”  Soon, Secretary Yellen will help to determine what happens with the tariffs levied against Chinese imports, she will help decide if the Trump administration protections for American intellectual property will continue, and she will likely have significant input on whether China will be labeled a currency manipulator (which serves little purpose, other than to be a finger in the eye of China).

The possible change in focus from Wall Street to Main Street, especially when considered with the potential underpinnings of the Fed’s 2% long-term inflation goal, may be frustrated by the ballooning debt and deficits.  A goal of letting the economy “run hot” for periods of time was that it was believed that a benefit of the tight employment environment was that real wages, wage growth relative to inflation, increased for a broader swath of the workforce, especially low-skilled Americans.  A potential problem with Janet Yellen’s view that deficits are fine because the current level of interest rates is low, is that it misses the impact of interest rates rising, which is a reasonable biproduct of massive fiscal spending and extremely accommodative monetary policy.  Stated another way, we could become victims of our own success.  If we let the economy run white hot, borrowing costs could increase, offsetting some of the benefits of the short-run economic gains with either short-term increased interest costs, or worse yet, the addition of long-term debt.  According to TreasuryDirect, the total interest cost for Treasury obligations in fiscal year 2020 was nearly $523 billion, down from $575 billion in 2019, likely resulting from plummeting interest rates in early 2020.  As a rough estimate, if interest rates were to reverse, while the principal amount outstanding increased by approximately 20%, our annual interest cost on our debt could approach $700 billion.  Add another $20 trillion to $30 trillion to the debt over the next decade and at a point, we have enjoyed a lot of consumption and left the next generation in a debtor’s prison.  This all seems to accelerate if we lose the enviable position of being the world’s sole reserve currency.  Count on that in our lifetime.         

"If we let the economy run white hot, borrowing costs could increase, offsetting some of the benefits of the short-run economic gains with either short-term increased interest costs, or worse yet, the addition of long-term debt."

Near-term, we expect rates will rise as the COVID vaccine becomes more widespread and the new round of stimulus dollars start to circulate. This could be further amplified by democrat plans to rapidly get additional $2,000 per person stimulus checks in the hands of voters.  As an indication of the state of consumers, a Financial Times survey conducted in June of those with incomes under $100,000 found that roughly half planned to use the money for basic expenses and just under half planned to save the money.  It suggests that the pandemic is hitting some families hard and others who have been less impacted are cautious about the prospects for their financial future.  Of the respondents, only about 10% planned to make discretionary purchases.  It may indicate that the pesky “demand” problem the government has had for more than a decade may persist.  You can give people “free money”, but can you make them spend it?  The December ISM Manufacturing release, which had a surprisingly high reading of 60.7, up from 57.5 in November (a reading above 50 suggests growth) may tell a related story. The market interpreted the fact that a measure of manufacturing customer inventories was at 37.9 suggests that both demand and inflationary pressure will ramp up in the future, but what if the manufacturer’s customers are keeping inventories skinny because they are being cautious about their economic futures?  Caution seems to be the most prudent path as the pandemic has made a mockery out of most forecasts.

Our short-term call for higher interest rates, followed by an economy that stalls and falling interest rates, is partially due to stimulus programs, Fed/Treasury support, and vaccine euphoria, but it is also influenced by mean reversion influences and the expected flow of information in the coming months.  Sequentially, we should start with the flow of information and how that may season growth expectations.  As we near February, March, and April, when people will have stimulus dollars in their hands, year-over-year comparisons may start to suggest strong levels of inflation.  Given the massive economic contraction in early 2020, comparisons in 2021 versus the same months in 2020 will suggest rapid growth. Any comparison to “zero” looks terrific and these “base effects” run the risk of making the market too optimistic about the true and sustainable pace of growth. 

Once investors start to extrapolate the growth metrics that come from the economy moving from being flat on its back to a standing position, market yields may trend higher and fixed income yields should climb.  There is a lot of potential energy that could cause the move to have some heft behind it.  In late December, Bloomberg data showed that more than 70% of global debt had yields that were below 1%, with almost 30% of the debt having negative yields.  The breakeven rate (a measure of inflation expectations derived from U.S Treasury Inflation Protected Securities (TIPS)) indicated that inflation is anticipated to exceed 2%, the highest reading since 2018.  The resulting 10-year Treasury real yield (the difference between a coupon paying 10-year Treasury and 10-year TIPS) fell to a record low of minus 1.12% at the start of 2021.  

Also of interest, credit spreads (the additional yield investors demand for taking on credit risk as compared to a like-term Treasury) have significantly recovered to the point they are nearly where they were at the start of 2020 (before the pandemic-related panic).  The combination of low Treasury yields and modest risk spreads at the end of 2020 have resulted in yields on high-risk borrowers reaching the lowest on record.  This seems tenuous as a significant part of the recovery was based on Fed purchases in this area to support prices and offer high-risk companies access to the capital markets.  This could be an area of volatility in 2021.  Low yields have driven market-rate coupons of most debt lower, which adds to the interest rate risk of the sector.  At the same time, some large (formerly investment grade) “junk” bond issuers, who in the past were able to issue long-term bonds, have pulled the average maturity of the “junk” bond indexes farther out, further adding to the interest rate risk of the sector.  If the incoming Treasury Secretary and the Fed pull their support away from this sector while the interest rate and credit risk volatility has increased, it could spell trouble.    

"If the incoming Treasury Secretary and the Fed pull their support away from this sector while the interest rate and credit risk volatility has increased, it could spell trouble."

It leads to the main reason why we expect the growth story will stall out.  Much of the massive debt assumption in the market in 2020 was for survival, not to fund productivity improvements and future growth.  Saddled with “unproductive” debt and in the face of an uncertain longer-term demand picture, along with an increased regulatory and tax environment and unrelenting global competition, it seems unlikely that businesses and investors will be aggressive with both hiring and expansion decisions.  Although we are supportive of a tight labor market to encourage broader economic participation and wealth for more Americans, private sector job growth may be elusive.  We do not anticipate that public sector jobs and private sector subsidies will be able to compensate on a net basis for the lack of job growth.  There may even be public push-back on off-setting public job creation efforts due to fairness concerns.  According to a 2017 study by the non-partisan Congressional Budget Office, for those with a bachelor’s degree, Federal workers receive wages that are 5% better than their private sector counterparts and their total compensation is 21% higher. Federal workers with a high-school education have wages that are 34% higher and total compensation is 53% better than private sector workers.  If jobs become scarce, expect people to concern themselves with such matters.      

In 2021, we anticipate rates will move higher as some strong growth numbers grab headlines and eventually trail lower than current levels.  This forecast may translate into a 10-year Treasury yield that trends toward 1.50% and may see a spike that dabbles with 2.0%.  As debt burden concerns emerge, along with stubbornly low long-term job creation numbers, and the degree of economic damage caused by the pandemic become evident, a slow-growth reality will set in and yields may fall in late 2021 or early 2022.  We see the largest risk to this forecast coming from the Fed embracing yield curve control and other measures to keep yields low and further obfuscate market prices.       

Municipal Bond Market – If They Can Make It Here, They Can Make It Anywhere

There will be massive challenges for small segments of the muni market, but at the end of all of this, we expect investors will see the credit risk aspect of municipal bonds as one of the safest broad asset classes in the market (independent of Treasuries).  More than a decade ago, most municipal market deals came with insurance and a “AAA” rating, making it a homogeneous (high quality) market driven by the level of interest rates (a “rates” market).  Following the Great Recession and the demise of most of the bond insurers, investors needed to learn how to perform credit analysis on these varied issuers and the muni market traded more based on sector risk and an individual issuer’s credit risk (it became a “credit” market).  It is currently thought of as being a “credit” market.  Given the relatively small number of “essential purpose” issuers that we expect will have issues because of the pandemic, we expect that the market will split and the part of the market that is rated “AA” or “AAA” will become a “rates” market, while the “A” rated and lower part of the market continues as a “credit” market.  

The risk that we are focused on in the muni market is substitution risk.  This can come from alternatives to how people access the goods and services they desire.  This risk may be the credit risk key for the near future.  For example, if someone wants to work in Manhattan but technology has made it so they can commute electronically as opposed to figuring out the transportation myriad related to where they can afford to live and where the employer is situated, a risk has become introduced to the transportation system, Manhattan area (New York City) sales tax collections and property taxes (as area businesses lose customers, their ability to pay astronomical rents decreases).  Another example would be if students warm to online learning.  Assuming online degrees are rewarded in the job market as well as in-person learning, students who are satisfied with a different type of education delivery, and while meeting their social needs away from a campus setting may save a lot of money by accessing their college education through non-traditional means (using pre-pandemic norms as a benchmark).  The commonality of the two examples is that they have massive fixed costs and sticky variable-costs that cause massive challenges when revenue (demand) proves to be more volatile than previously thought.  In some cases, substitution may help to save some sectors. Healthcare systems may benefit greatly in a single payor environment if they can address some needs and manage the care queue with virtual visits.  We will be spending considerable energy trying to reimagine how public and quasi-public services will be accessed, along with tracking changes in preferences in 2021.