A flagging consumer price index contains the bear market in bonds

Part 3
A flagging consumer price index contains the bear market in bonds (Part 3 of 5)

Federal Reserve’s assets surpass $4 trillion: Effect on investors

Fed assets

The below graph reflects the Federal Reserve Bank’s “war on deflation.” Since the economic crisis of 2008, the Fed has increased its purchase of bonds (“assets”) in an attempt to provide liquidity (“cash money”) into the U.S. banking and financial system. Much ado has been made in the political world about this large, somewhat interventionist role played by the U.S. central bank. With a $15.6 trillion gross domestic product, it would appear that the Fed has injected roughly 25% worth of cash liquidity into the U.S. financial system since the 2008 crisis and shows signs of continuing to grow assets or purchases of bonds. Despite the decline in purchase rates from $85 billion per month to $75 billion, the Fed may continue to add roughly $900 billion in assets (bonds) to its balance sheet this year.

This article considers the ongoing growth in the Federal Reserve Bank’s (the Fed’s) assets and the implications for fixed income investors. For a detailed analysis of the U.S. macroeconomic environment supporting this series, please see Must-know 2014 US macro outlook: The crack in the debt ceiling.

Federal Reserve Bank Total Assets ($ Trillion) 2014-02-18Enlarge Graph

Fight the Fed?

As a general rule, it’s not a good idea to take a position contrary to the explicit goals of a central bank. While a few lucky investors have done so—such as George Soros when he made his first $1 billion gain in shorting the British pound in 1992—most contrarians don’t fare so well. Central banks around the world are continuing to pump cash liquidity into the global financial system. As above, the USA has done so to the tune of 25% of GDP. The Japan Central Bank has done so to the tune of nearly 50% of GDP so far, or $2.7 trillion.

Is the Fed losing its control over deflation?

On the other hand, the recent weakness noted in the declining consumer price index (or CPI) data in the first part of this series would suggest that, even with large-scale asset purchases, the Fed has yet to convincingly slay deflationary pressures in the U.S. economy. Asset purchases continue to grow, though CPI data seems to be trending downward, and the trajectory of CPI isn’t yet convincingly at or above its targeted level of 2.0% per annum, or slightly higher. This data bears watching very closely, as an ongoing failure of the Fed to hit its CPI target would suggest that deflationary pressures are worse than expected, and that the bear market in bonds may not be in the offing. On the other hand, a sudden rise in the CPI data would suggest that the Fed’s policy measures have been working—albeit with a significant lag in effect—and that they have the deflation situation fully under control. Many investors fear a sudden rise in inflationary data and sharply rising interest rates more than the ongoing 1.0% to 2.0% below target CPI data.

To see how global central banks’ purchase of $9 trillion in assets is affecting interest rates, please see the next article in this series.

For additional longer-duration alternatives to LQD and AGG, please see the series on fixed income ETFs Key strategy: Will deflation contain the bear market in bonds?

Short duration, higher credit risk: SNLN & BKLN

If investors are concerned about a rising rate environment, they may wish to consider short-duration fixed income exposure through short-duration fixed income ETFs such as the Highland/iBoxx Senior Loan ETF (SNLN). This ETF holds senior bank loans, which offer a floating rate coupon based on short-term interest rate pricing—typically the 90-day interbank rate, known as “three-month LIBOR.” (LIBOR stands for the “London Interbank Offer Rate on Deposits,” and it’s established daily through a consortium of banks under the British Banker’s Association in London.)

Similarly, the Invesco PowerShares Senior Loan Portfolio ETF (BKLN) also holds senior bank loans and also has a short duration. The duration of these “floating-rate” loans is typically 40 to 60 days—much shorter duration than the typical four-year duration associated with similar corporate five-year bond portfolios. The loan portfolios also carry an additional advantage over longer-duration corporate bonds in that they have a much higher average recovery of loss rate compared to corporate bonds—closer to 80% compared to closer to 50% in the case of similar rated bonds.

It’s important to note that both these ETFs invest in loans that are rated in the BBB-B area and involve more risk of loss than portfolios rated in the AAA-A area. However, what they lack in credit rating they tend to compensate for in terms of higher returns. SNLN offers a yield-to-maturity of around 4.8%, and BKLN around 4.95%.

Longer-duration, lower-credit-risk alternatives: AGG & LQD

If you’re wary of credit risk, you could also consider longer-duration ETFs such as the iShares Core Total U.S. Bond Market ETF (AGG). It maintains a duration of 5.11 years, though it has a yield-to-maturity of 2.14%, as it holds roughly 70% of its portfolio in AAA and AA rated bonds. Similarly, the iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD) offers a duration of 7.49 years and a 3.35 yield-to-maturity, and it holds the majority of its bonds in the A to BBB category. Like LQD, AGG also holds high-quality commercial credits, such as Verizon (VZ)(0.09%) and GE Corporation (GE)(0.08%). Like SNLN, BKLN also holds lower-rated commercial credits, such as Fortescue Metals Group (FMG)(1.96%) and Valeant Pharmaceuticals (VRX)(1.48%). Note that the individual holdings of BKLN and SNLN are much larger than the holdings of the higher-credit-quality holdings of LQG and AGG, reflecting the greater diversification and the lower level of default-related losses associated with AGG and LQD.

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