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A flagging consumer price index contains the bear market in bonds

A flagging consumer price index contains the bear market in bonds (Part 1 of 5)

Fixed income must-know: Why the Fed struggles to create inflation

Inflation in the U.S.

The below graph reflects the Federal Reserve Bank’s struggle to maintain a modest level of inflation in the U.S. economy. The Fed would prefer to keep inflation running around 2.0% per annum, providing banks and consumers the protection they need from declining asset prices. As we mentioned in an earlier articles, banks become reluctant to lend against assets that decrease in value, and the average American consumer becomes reluctant to spend when the value of his home declines.

This article considers the Federal Reserve Bank’s continued struggle to reach its inflation target 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.

USA Inflation Rate (CPI) 2014-02-18Enlarge Graph

Too much supply, not enough demand

The above graph would suggest that the U.S. economy suffers from an excess supply of goods and services and a lack of final demand for these goods and services. The decline in the unemployment rate is largely due to the retirement of the Baby Boomer generation and discouraged workers leaving the workforce, with the labor participation rate at ’70s-era lows of 62.8%. The decline in the unemployment rate for 2013, from 7.5% to 6.7%, has been due to many people no longer being counted in the workforce, with 548,000 leaving the workforce in the past year, according to the St. Louis Fed. Since 2010, the U.S. civilian workforce not in the workforce had grown from roughly 153.2 million to 155.8 million in 2013, with the associated loss of 2.5 million workers accounting for nearly 2.5% of the 3.3% improvement in the unemployment rate.

Supply and demand rebalance

While the decline in labor force participation due to discouragement isn’t a positive development, it is possible that the retirement of the Baby Boomer generation could improve the employment outlook for those under the age of 50, who often have more education and training in modern technology or computers than their predecessors. The continuance of this trend may mean an ongoing decline in the workforce as the elderly retire, though younger workers should be able to fill in this gap and thereby contribute to economic growth. For more research pertaining to the different types of unemployment data, including the U-1 through U-6 worker, please see the related article Is US employment a positive or negative for stocks?

The China factor: China exports deflation

As far as the supply of goods is concerned, low-wage manufacturing work in China continues to contribute to the decline in low-end manufacturing in the USA, which has fallen from nearly 25% of the U.S. economy in 1970 to closer to 12% of the U.S. economy today. For more analysis of the impact of China’s manufacturing and trade on the U.S. and global economies, please see the related series Slowing export growth rates cull China’s equities.

For fixed income investors

For fixed income investors, deflation can contribute to lower interest rates and higher bond prices. However, should deflation persist, the economy could weaken, and lower-quality bonds could face declines due to the deterioration of credit quality. In other words, U.S. Treasuries and very-high-quality credits might remain a good investment in a very-low-inflation or deflationary environment—though if inflation reaches or exceeds 2.5% and the economy returns to a 2.5% or higher trend growth, the highest-quality bonds, including U.S. Treasury bonds, would also likely see a decline in prices and a rise in yields.

To see why the current levels of real interest rates in the USA are containing the bear market in bonds, 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. LDQ includes higher commercial credits such as Verizon (VZ)(0.70%) and Blackrock Funds (BLK)(0.67%), whereas SNLN holds lower-rated commercial credits such as Caesar’s Entertainment (CZR)(2.35%) and Hudson’s Bay Company (HBC)(1.50%).

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