Hold on—we’re halfway there
The Bureau of Labor Statistics defines U-4 unemployment as “total unemployed plus discouraged workers, as a percent of the civilian labor force.” As we noted in a prior series on “the discouraged worker,” discouraged workers number around 450,000 of the total 98,000,000-strong workforce. Discouraged workers numbered as low as 200,000 during the Clinton Administration’s strong economic conditions, though as high as 700,000 in 2009, after the financial crisis. While stocks and bonds are both 20% higher relative to their prior 2007 peaks, both labor markets and housing markets reflect a 50% recovery from the post-crisis bottom, relative to the 2007 peaks. This article considers the halfway mark improvement in the U-4 labor data and the implication 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.
Improving labor conditions: Living on a prayer?
The above graph would suggest that the labor market is halfway back to more normal conditions. The target for U-4 would be right around the NAIRU (non inflationary rate of unemployment) level of 5.6%—plus 0.2% to 0.40% to account for the 200,000 to 400,000 discouraged workers in the labor market. With the U-4 unemployment rate reaching 7.0%, it’s possible that this rate could reach a more normal rate of under 6.0% in one year. That is very encouraging. However, should taxes rise and wages stagnate, the U-4 workers returning to the labor markets may not be happy with their purchasing power. As we discussed in the prior article in this series, the Republican party will likely push for cuts in spending after the mid-term elections this fall in order to pare down the government debt level, which grew from roughly 40% of gross domestic product to 80% of gross domestic product post-2008 crisis. The Democrats will likely push for higher tax rates for the rich. Perhaps economists like Paul Krugman will have some ideas as to how to grow the economy via demand-side issues by next year. Supporting labor market improvement while maintaining entitlement responsibilities—while also slowly paying down the debt level—would be a positive outcome for all parties. Perhaps this is in the works.
While the levels of discouraged workers in the U.S. labor market are excessively high by historical standards, the sheer number of discouraged workers—who are no longer drawing unemployment benefits—is more of a social justice issue than an economic one. Mandatory spending as a percentage of the U.S. budget had historically been around 1.5% of GDP, though it reached as high as 3.0% of GDP during the crisis. This level of spending has dropped to 2.0% currently—once again, halfway there. Keep in mind that U.S. tax receipts are only 16.7% of GDP (though government expenses are closer to 20.0% of GDP). The difference between 1.0% and 3.0% of GDP pertaining to unemployment benefits is the difference between 6% and 18% of the Federal budget. Not exactly small potatoes. Regardless, given the continuation of overall improvement, the trend may continue to be the investor’s friend—especially for those invested in risk bearing investments such as equities and below–investment-grade credit.
To see how the U-4 unemployment compares to the unemployment rate that also includes “those marginally attached to the workforce” or “U-5 employment,” please see the next article in this series.
For more detailed analysis of the U.S. labor market, please see Is Baby Boomer retirement more good news for stocks and labor markets? and US labor: Is the discouraged worker bad for stocks and bonds?
Credit comment: The below–investment-grade Sprint
Sprint (S) has a market capitalization of $36.17 billion (the value of all its equities), and it’s considered a high yield credit. Its debt is considered below the investment-grade cut-off of “BBB” rating, as it’s in the BB (junk bond or below–investment-grade) category. Reducing the firm’s $33 billion of debt by the $7.47 billion of cash holdings leaves approximately $25.5 billion of net debt, and a 1.29 debt-to-equity ratio. However, given the last quarter profit margin of -8.50%, the firm has seen a negative 18.48% return on equity. Sprint is a large company with $35.49 billion in sales revenue, and it still has $5.47 billion in earnings before interest and taxes (EBITDA) to service its net debt of $25.5 billion.
This is sufficient debt service capability, though a weakening economic environment in the USA could compromise the debt service ability in the future. With $48.57 billion in EBITDA and $42 billion in net debt, Verizon is clearly in a much stronger financial position than Sprint. Unless we see labor and productivity increases in the future, companies with weaker earnings margins like Sprint could face further pressures on their bond prices and higher yields. However, the 2013 Softbank merger or acquisition and capital infusion of $5 billion may also improve Sprint’s credit outlook and operating health going forward. While Sprint is in fairly stable condition, it’s not as strong as its competitor, Verizon (VZ), with relatively lower debt levels and more cash on its balance sheet. Sprint currently has an August 15, 2007, senior unsecured bond yielding 2.95%, versus Verizon’s February 15, 2008, senior unsecured bond yielding 2.00%, T-Mobile (TMUS) US’s February 19, 2019, senior unsecured bond yielding 3.00%, CIT Group’s February 19, 2019, senior unsecured bond yielding 3.46%, and Caesar’s Entertainment’s June 1, 2017, senior secured bond yielding around 11.00% (Bloomberg & Capital IQ, December 31, 2013 Quarter).
Outlook: High credit quality and longer duration (TLT & BND) versus lower credit quality and mid duration (HYG & JNK)
For fixed income investors concerned with rising interest rates and falling bond prices, long-dated (long duration) ETF’s such as the iShares 20+Year Treasury Bond ETF (TLT) may continue to see price declines, should interest rates continue to rise. Note that the TLT ETF has a duration of approximately 16.35 years—roughly twice that of the current 10 Year Treasury Bond at 8.68 years. In contrast to the long-dated TLT, the iShares iBoxx High Yield Corporate Bond ETF, HYG has a much shorter duration of only 3.98 years, as well as exposure to improving commercial credit markets, and may continue to outperform the long duration TLT ETF in a rising rate environment.
However, it should be noted that the High Yield portfolio of HYG holds roughly 90% of its portfolio in bonds rated BBB3 through B3, with roughly 10% of its portfolio in CCC-rated credit (substantial risks). HYG top holding includes Sprint Corp (S) at 0.56% of the portfolio. The Vanguard Total Bond Market ETF (BND) maintains a duration of 5.5 years, though holds 65.4% of its portfolio in government bonds and 21% of his holdings in AAA-A rated bonds. In comparison to HYG and JNK, the BND ETF is slightly longer in duration (BND 5.5 years versus HYG 3.98 & JNK 4.20), though is very much concentrated in government and high quality bonds, and will therefore be less impacted by changes in the overall commercial credit markets.
Lastly, for investors looking to maintain yield while gaining exposure to the commercial credit market, an alternative to the iShares HYG, the Barclays High Yield Bond Fund ETF (JNK) offers a similar duration of 4.20 Years versus HYG 3.98 years, holding 84.17% of its portfolio in Corporate Industrial, 7.65% in Corporate Utility, and 7.5% in Corporate Finance-oriented bonds. Like HYG, even JNK is a big fan of Sprint (S), with its top holding of First Data Corporation (0.72%) followed by Sprint Corp, S, (0.62%), Sprint Communications (0.59%), and HCA Inc (HCA).