Bond Funds: Are They Safe or at the End of Their 32-Year Super-Cycle?
Seminar as of January 16, 2014 – Amit R. Stavinsky, Tamar Securities, LLCGlobal Macro Economic Trends
Two Secular Trends Threaten to End the U.S. Golden Age of Economic Growth
Since World War II, America has been the envy of the world, growing at an average annual rate of 3.5% for most of that period. However, two secular trends threaten to end this Golden Age of economic growth, slicing the postwar rate by about half below current Wall Street consensus estimates. (The GDP growth rate estimated by most economists for 2014 is approximately 2.8% for the next two decades. JP Morgan economists project average annual GDP growth of just 1.75% over the next five years). It is very important to understand some of the global demographic trends that are taking place because they have the potential to lead to a prolong subpar GDP growth and high unemployment at home and abroad, and at the end overwhelm any monetary stimulus policies that are designed to counteract these effects. The following are few of these potential disruptive megatrends.
ONE: The Size of the Working-Age Population
Population Growth
Bureau population projections indicate slower population growth over the next three decades due to less net immigration into the U.S., and a lower than expected birth rate. The lower immigration rate results from a weaker U.S. economy, relatively high unemployment, and tighter security across the U.S. Mexican border. The U.S. working age population (Americans from 18 to 64 years of age) is projected to grow only 0.36% during the current decade, and then limp along at even lower rates from 2020-2030. That’s well below the 1.81% rate that prevailed during the 1970s. What was a demographics’ economic benefit, now acts in reverse as boomers start to retire in large numbers and sharply raise their financial dependence on workers whose taxes fund their costly entitlement programs.
Income Inequality
Due mostly to educational gaps, 52% of the U.S. income growth currently goes to the top 1% of earners. On the other hand, citizens in the bottom 99% of income continue to experience stagnant wages, which in turn adds to the social cost of slow growth. Also, overall real U.S. household median income has fallen over the past six years about 7%—from $54,892 in 2006 to $51,017. Much of that decline can be explained by the Great Recession and the laggard recovery. But some of this decline can also be attributed to income inequality among minority groups (according to a recent study by Cornell University economist Richard Burkhauser and Jeff Larrimore). For example, mean incomes of minorities in the U.S. have remained at about 60% of white incomes in recent decades. Unless that pattern changes, and minorities can earn higher incomes, the overall economy can slow down as the baby boomers, predominantly white, retire over the next 20 years.
Aging Population and the Labor Participation Rate of All Americans
The U.S. population that is over 65 years of age is projected to rise from 13% to 20% over the next 20 years. At the same time, the minority population, particularly Hispanic, is estimated to grow from around 16% of the population to nearly 22% by 2030, and 28% by 2050. If income relationships remain the same, U.S. median income growth will drop by an estimated 0.43 percentage points a year through to 2020 and 0.52 percentage points a year over the succeeding decade. In addition, contributing to potentially slowing economic growth, is the steady decline in the U.S. labor-participation rate from 66.2% in 2006 to 63.2% in August of 2013, and most recently 62.8% (according to the Bureau of Labor Statistics which computes the number by dividing all workers by the number of Americans over 16 years of age).
Subpar Growth in the Rest of the World
The entire world is aging. Most famously, Japan’s retirement-age population has risen steadily. It is expected to hit 26% of the total population by 2015, and top 29% by 2025 (according to the United Nation’s Population Division). Hong Kong’s 65 or older population is expected to make up 15% of the population in 2015, hitting about 22% in 2025. Singaporean retirees are projected to constitute 11% of the population in 2015, and that number is expected to grow to 17% by 2025. Lastly, in China the 65-plus group is on track to grow from 10% in 2015 to nearly 14% in 2025 (According to the U.N. figures). The same trend is well under way in Europe. For example in Germany and France the retirement age is already above 20% and forecast to rise to 25% by 2025. Even emerging European economies such as Poland, those 65 years of age or above are expected to hit 15% in 2015 before growing to 21% by 2025.
TWO: Productivity
Over the past three years, nonfarm labor productivity increased at only 0.7% annual pace (JP Morgan economists: Michael Feroli, and Robert Mellman recently pointed that out in a report entitled “U.S. Future Isn’t What It Used To Be: Potential Growth Falls Below 2%.”). This compares with the post World War II average annual boost to GDP of 2.3%, and the 2.9% average yearly rise for the decade ending in 2005. This might be a result of slower growth in spending on private research and development that has fallen from an average of 4.7% a year between 1980 and 2000 to 2.8% per year in the last 10 years; thereby, jeopardizing future innovation and contribution to newer products that can deliver faster processing speed and cost savings.
Projections for slower population growth, income inequality, aging population, falling labor participation rates, and lower annual productivity rates at home and abroad can all point out to a lack luster Gross Domestic Product Growth over the next 20 years or so. This in turn, can lead to low interest rate environment over the long haul albeit some short term bursts in interest rates in response to potential fiscal and monetary stimulus efforts to keep the economy growing. In this economic environment of near-stall speed GDP growth rate, fiscal and monetary policies will be more difficult to administer. With less room for error, policy miscalculations can either unleash unintended spasms of inflation, recessions, or unemployment. One such policy intended to improve unemployment and inflation is Quantitative Easing of monetary policy.
The Federal Response
Quantitative Easing of Monetary Policy
Purchase of $75 billion* Per Month of U.S. Treasury Bonds and Mortgage Backed Securities
During the last Federal Reserve’s meeting, the central bankers agreed on cutting their monthly bond purchases to $75 billion from $85 billion, taking the first step toward unwinding the unprecedented stimulus that Chairman Ben S. Bernanke put in place to help the economy recover from the worst recession since the 1930s. The Fed’s purchases are now divided between $40 billion in Treasuries (as of May 23, 2014 at approximately $25 billion), and $35 billion in mortgage bonds (as of May 23, 2014 at approximately $20 billion). Bernanke, in the final weeks of his eight-year tenure curtailed the purchases that swelled the Fed’s balance sheet to $4 trillion. (*As of May 23, 2014 at approximately $45 billion.)
Fed Fund Rate
Inflation Rate at Less Than 2.5%
The central bank will probably hold its target interest rate near zero at least as long as (per the central bank statement from the December17-18 policy meeting) the outlook for inflation is no higher than 2.5%.
Unemployment Rate of Over 6.5%
(as of May 23, 2014 at approximately 6.3%.)The central bank will probably hold its target interest rate near zero at least as long as [per the central bank statement from the December17-18 policy meeting] the outlook for unemployment exceeds 6.5 percent. The panel added in its last meeting that it will likely be appropriate to maintain the current target range for the Federal Funds Rate well past that time that the unemployment rate declines below 6.5 percent, especially if projected inflation continues to run below the Fed’s 2 percent goal.
10-Year U.S. Treasury Yields
The extra yield on 30-year Treasury Bonds (3.88%) (as of May 23, 2014 at approximately 3.39%) over 5-year Treasury Notes (1.749%) (as of May 23, 2014 at approximately 1.52%) shrank to the narrowest in three months: to 213 basis points from 256 basis points (as of May 23, 2014 at approximately 187 basis points) after the central bank said in December 2013 it would reduce monthly asset purchases to $75 billion from $85 billion. Slow inflation can help cap Treasury yields according to Fidelity Investments. A scenario such as this indicates narrowing spreads between short and long maturities, flattening of the yield curve, and a crushing rotation out of the 5- and 7-year notes and into the longer maturities.
Q.E. Tapering
Projections are that the Federal Reserve will continue reducing monthly bond purchases in $10 billion increments over the next seven meetings before ending the program in December 2014 as long as economic growth and employment don’t stall. That said, even once tapering begins in January, the Fed is committed to keeping short-term rates near zero into 2015. Moreover, the US economy will probably need stronger growth and higher inflation to sustain a 10-year yield much above 3 percent.
Some of the benefits resulting from one of the most aggressive quantitative easing policies in recent memory include a recent decline in the U.S unemployment rate to 6.7% (as of May 23, 2014 at approximately 6.3%) albeit low participation rate of only about 62.8 percent. Employment rose in December 2013 by 74,000 new jobs-at the slowest pace in almost three years, in part because of bad weather; however, for the past two years employment increased by about 4 million jobs (166,000 average new jobs per month). Additional Quantitative Easing benefits include:
Global Economic Recovery*
Synchronized Monetary Stimulus
A global synchronized monetary stimulus in Europe and Japan of 0-25 basis points target Fed Funds rate and aggressive local Treasury purchases, to name a few, already point to positive results. In Japan, this policy marked the end of a five-year period of macroeconomic uncertainty that depressed equity prices and drove their risk-premium to a 60-year high.
Europe’s Manufacturing PMI
In peripheral Europe, the composite index of new orders’ manufacturing; Purchasing Managers Index (PMI), stands at the highest level since mid-2010.
Global Job Growth
The global employment picture has improved as the global economy created almost 100 million new jobs, with strong gains in China, India, Brazil, Indonesia and Mexico.
Corporate Private Sector
U.S corporate cash flow as a percent of GDP, cash on hand, and return on assets are all close to all-time high levels, while corporate leverage and financing costs are all close to all-time lows.
Consumer Sector
The U.S consumer continues to deleverage meaningfully to a point in which the household debt service ratio that measures debt payments as a percent of personal disposable income now stands at an all-time low level. This is important as consumption is approximately 70% of the U.S. GDP while government spending is only around 19%. Also, according to JP Morgan, total consumer-equity and home-equity net worth is now around $36 trillion, back to the 2006 level. It has increased by approximately $9 trillion since the beginning of 2012. This wealth effect should have positive implications for future consumer spending trends, and therefore GDP growth. It also overwhelms the increase in the Fed’s balance sheet to approximately $4 trillion.
Government Sector
The government sector itself is on an improving trajectory. The budget deficit is shrinking from a recent 10% level to a run rate of 4% in 2013. Across America the credit profile of local governments seem to be improving as property valuations rise, local sales and income-taxes increase, and major reform of public employee pension plans accelerates. *[Source: Alkeon Capital Management 2Q, 3Q, and the December 2013 letter.] In summary, the benefits of a coordinated global stimulus policy can overwhelm the effects of subpar GDP growth worldwide and global demographic changes. These effects can lead to the following.
The End of the 32-Year Super-Cycle in Bonds
For only the second time in the past 40 years (last time was in 1998)*equities are up and bonds are down. [* Source: JP Morgan, US Strategy, June 2013.] This was partially the result of the following Early Stages of Economic Recovery:
Risk-Free Rate
During early stages of economic recovery, capital is normally allocated away from the “fear trade” namely bond funds and into equities. In particular, as long as the 10-year U.S. Treasury yield is below 5%, there is generally a positive correlation between higher yields and U.S. stock prices.
Equity Premium
Also, during these beginning stages of an economic recovery (such as the one some agree is currently taking place in the U.S.), when interest rates increase slowly due to improved confidence in the economy, equity risk premiums tend to generally decrease because stocks are perceived as less risky. This effect can be net positive for stocks and in general net negative for bonds.
Inverse Relationship between Equities and Interest Rates
As long as the 10-year U.S. Treasury yield is below 5%, there is generally a positive correlation between higher yields and U.S. stock prices. Above the 5% level, the relationship then can invert and become negative for equities and positive for bonds.
Growth in Equity Cash Returns: Consumer Discretionary, Technology, and Healthcare Stocks
In general, high free cash flow yielding stocks that are currently somewhat inexpensive, and therefore offer high levels of cash returns in the form of both dividend distribution and buybacks, can also attract capital away from fixed income investments. Specifically, in 2013, the three highest share repurchase groups in the S&P 500 were consumer discretionary, technology, and healthcare stocks at 3.9%, 3.6%, and 3.5% of their market value respectively. Overall, the level of cash returns namely dividend plus share buybacks reached an all time high of $821 billion as of August 2013. This represents an approximate 4.6% cash yield, or 40 basis points above the yield on investment grade bonds. *[Source: Alkeon Capital Management 2Q, 3Q, and the December 2013 letter.] These cross-current events of early stages of U.S. economic recovery, new global demographic trends, and synchronized easing of monetary policies around the world should reposition investment portfolios for higher volatility risk and capital reallocation.
Assets Reallocation and the Inherent Risk of Bond Funds
Yield Reassessment
Record out flows from bond mutual funds and exchange trades funds (ETFs) in 2013.
Two thousand thirteen marked the first in four years of negative returns in the bond market. As the 10-year U.S. Treasury yield advanced from 1.76% at the beginning of the year to approximately 3% by year-end, bonds retreated (as of May 23, 2014 at approximately 2.53%). The net result was a record inflow into equity funds of about $160 billion, the most since 2000. According to data compiled [Bloomberg and Washington-based Investment Company Institute], while bond mutual funds and exchange traded funds saw redemptions of about $80 billion, $62.7 billion were redeemed out of Municipal Bond Funds, the most since at least 1992, when Lipper U.S Fund Flows data begin. Lastly, about $260 billion had left stock funds the previous four years as more than $1 trillion were added to bond funds.
Volatility risk.
Estimated higher volatility risk in both the bond and stock markets as a result of, at times, excessive stimulus policies used to jump start a slowing economy, typically also bring about excessive moves in interest rates. For example, it is not unlikely to assume that during this year the 10-year treasury market will test the 3-3.25% level. It is important to conduct an ongoing yield reassessment analysis by comparing different income asset classes. For example, Municipal bonds paying north of 4.5% double tax-free income, and high paying Dividend stocks paying 3% might be more attractive than convertible bonds, Treasuries, Real Estate Investment Trusts, Preferred Stocks, Master Limited Partnerships, and junk bonds paying respectively anywhere from about 2%-5% taxable returns.
Perpetual maturity of bond funds and their inherent interest rate risk.
At this new juncture of capital reallocation, bond mutual funds suffered the most in 2013. This is mostly due to the fact that bond holders don’t own the underlying securities but rather a minute percentage of a pool of individual bonds. In this case, the bond fund holder owns a perpetual maturity of bonds; and therefore, exposed a lot more to interest rate risk than a direct owner of individual bonds’ portfolio with a set maturity.
Tax selling of bond funds.
To make things worse, tax selling of bond funds in order to lock in losses to offset capital gains taken throughout the course of 2013 in the equity market, have further contributed to this asset class negative returns. So what should an income investor do during times of heighten volatility risk in the bond market? How can one take advantage of any present or future market dislocations?
Income Alternatives
Individual Bond Holdings
Well, the good news is that in general bond funds’ redemptions should present individual bond buyers better opportunities to lock in higher yields-to-maturity at greater discounts-to-face value. Put another away, as some might say in Yiddish, no “hernia gets to the floor, and no hunchback touches the sky”. In other words, don’t look for the extreme highs or lows to lock in rates. In my professional opinion in an environment of subpar GDP growth rate for years to come along side some corrective stimulus policies that at times can result in unwarranted interest rate upswings, individual bonds should be bought whenever bond fund managers are forced to liquidate their bond holdings. At TAMAR our value-investment discipline emphasizes senior, discounted Municipal Bonds that pay the highest possible yield-to-maturity per a bond’s credit worthiness, coupon and maturity. A balanced value discipline such as that can yield an optimal risk-reward return on investments. That unique “sweet spot” in the market place, in the form of credit worthiness, coupon and maturity will inevitably adjust as the unemployment, inflation, and the GDP growth rate also end up adjusting. This value discipline should take advantage of market volatility risk by attempting to lock in discounted yields with set maturities that are less sensitive to interest-rate risk than bond funds.
Treasury and Junk Bonds versus Municipal Bonds
After a weak year for 2013, tax-exempt bonds may still be the most attractive area of the bond market. Top-grade 10-year Municipal Bonds yield 2.5% or more (as of May 23, 2014 at approximately 1.26%), while long-term issues yield 4.5%-5% (as of May 23, 2014 at approximately 3.8%). In some cases, senior debt such as A- rated California General Obligation Bonds that are backed by the unlimited taxation power of a state, a city, or a district that were issued recently with a 3%-4% coupon, at full face value, could have been bought in the summer of 2013 at approximately 80-85 (as of May 23, 2014 at approximately 93-95), paying a yield-to-maturity in 14-16 years of 4.60-4.90% (as of May 23, 2014 at approximately 3.70-3.90%) exempt from state and federal income tax not excluding capital taxable gains. (The taxable equivalent for high earners is approximately 11.5% per year). The later yield-to-maturity pays more than the 30-year Treasury Bond of 3.80% taxable return (as of May 23, 2014 at approximately 3.39%). And, more than junk bonds that yield on average only 5.7% taxable return (as of May 23, 2014 at approximately 4-5%). It’s also worth pointing out that historically tax-free bonds pay about 90% of the Treasury yield because of their tax-exempt status. In that case, Municipal Bonds maturing for example in 10 years when compared to a 10-year Treasury Bond paying a yield-to-maturity of 2.85% (as of May 23, 2014 at approximately 2.53%), should only yield 2.56% double tax-free versus their current yield-to-maturity of 4.6% (as of May 23, 2014 at approximately 3.76-3.90%) exempt from taxes not excluding capital gains. In other words, in some cases Municipal Bonds are so inexpensive that they currently pay about 180% (as of May 23, 2014 at approximately 146%) over the 10-year Treasury Bond.
Types of Municipal Bonds
There are two main types of Municipal Bonds: General Obligation Bonds and Revenue Municipal Bonds.
General Obligation Bonds. General Obligation Bonds are backed by the “full faith and credit” of a taxing authority which if necessary pledges to raise taxes with its unlimited-taxation power in order to pay its outstanding GO debt when due.
Revenue Bonds: essential services, such as sewer and water systems. Revenue Municipal Bonds are used to finance either a municipal facility or a project such as a department of water and power or a toll road; and hence, have a dedicated revenue stream from these facilities to pay interest and principal to bond holders.
Municipal Bonds: a unique asset class.
- Low default rate of 0.04% between 1970 and 2000. By comparison, the 10-year default rate for Corporate Bonds over the same period of time was 9.83% [Source: November 2002, Moody’s Investor’s Services.]
- Large market size of approximately $3.8 trillion.
- Generally liquid secondary market for sizeable offerings.
- Participants in this market include high-net-worth individuals, mutual funds, money market funds, property and casualty insurance companies and commercial banks
- Generally high-grade ratings.
- Availability of surety credit enhancement of interest and principal over an underlying rating.
- Attractive spreads over other income instruments such as corporate junk bonds and Treasury Bonds.
Summary
The potential end of the 32-Year Super-Cycle in bonds as a result of synchronized global stimulus policies and some indications of early stages of economic recovery, should once again shift income-oriented investors to individual bond holdings with set maturities. In an interest environment where monetary policies can overwhelm major secular trends of low-GDP growth rates and high-unemployment and low-inflation rates; at times, these types of corrective measures, in my opinion, can lead to rapid interest-rate swings that have the potential to generate total-return losses for bond funds holders as opposed to individual bond holders.