Fixed Income Return Summary
The high yield fixed income sector, which is highly correlated to equities, outperformed all other fixed income markets in 2016 by returning 13.22%. Longer municipals, as well as intermediate corporates, government, and treasury indexes all ended the year in positive territory. Shorter municipal bonds underperformed the market with a slightly negative return for 2016.
The 1st Quarter: A Conundrum
After the election last November, the bond market took a hit as both tax-free and taxable bond yields rose significantly. The chatter in the fixed income and equity markets was the Trump administration was going to get the economy growing again and interest rates would have to rise. Taxes were going to go down, the regulatory climate would be good for business, and there would be big spending on infrastructure and the military. Deficit spending would drive the economy forward and deflation would become yesterday’s problem. At the same time the Fed was committed to raise interest rates to combat possible future inflation and to provide breathing room for them to ease rates when the next recession came along. It appeared there was nowhere for interest rates to go but up. However, to everyone’s surprise, after the Fed raised the Fed Funds rate to 1.0% in March, the bond market rallied. The market was clearly too negative on interest rates. Fears of interest rates of 5.0% to 6.0% were clearly overblown. It will be difficult for rates to rise significantly higher since our interest rates are already very attractive compared to the rest of the developed world.
The Fed: Normalization of Rates
The Fed seems to finally be committed to normalizing overnight interest rates. There have been one quarter point increases in the Fed Funds rate at each of the Fed meetings in December and March. This has brought the Funds rate up to 1.0%. Fed members are calling for two or three additional increases this year. There is also talk by Fed members of possibly starting to shrink their balance sheet by year end. The balance sheet went from $900 billion in 2008 to about $4.5 trillion today because of Quantitative easing to get the economy going after the Great Recession. It will be interesting to see if the economy is strong enough for the Fed to follow through with raising rates and shrinking the balance sheet. There is no precedent when the Fed has raised rates while the economy was growing below trend and inflation was below target. The Fed has had a history since the financial crisis in 2008 of overestimating the future growth rate of the economy. Their forecasts have been more representative of wishful thinking than reality. However, the markets have recently started to believe their forecasts. We have been monitoring economic developments for signs of faster economic growth, but the economy is still growing slowly.
Normalized Yield Curve
Our research shows the average spread between the Fed Funds rate and the 10 year UST is about 150 bp’s. Using our research, today’s fair value for the 10 year treasury is 2.50%. The 10 year is currently trading at 2.25% which is 25 bp’s less than fair value. Inflation is running at 1.7%. if we add an additional 100 bp’s to the inflation rate we get a level of 2.7% for the 10 year. We still believe we are in a low interest rate environment for a long period of time. However, the current chatter from the Fed suggests they want to move rates higher. If we end the year with the Funds rate pegged at 1.50%, we would expect the 10 year UST to be closer to 3.0%. This change is based solely on comments from the Fed. Our forecast is for the economy to grow slowly and for inflation to be under the Fed’s target. If the economy does not strengthen and inflation remains subdued, it will be difficult for the Fed to raise rates much higher than they are now. An over indebted economy and negative demographics will create headwinds for the economy. Yet, relief from regulatory burdens will help the economy do better. We will be monitoring these developments to see how much reducing regulations will benefit the economy. The backdrop of possible higher Fed induced short term rates in a relatively weak economy should continue to be favorable for a bear flattening trade in the bond market. We continue to favor a barbell strategy for our portfolios.
Nuclear Power Past and Present
Nuclear power seemed to be the power of the future in the early 1970’s. However, the nuclear accident at three-mile island in 1979 changed the growth path of nuclear power plants. Many nuclear projects were canceled. The most famous casualty of this incident was Washington Public Power Supply System (WPPSS pronounced like Whoops!) who abandoned 3 different nuclear reactors in the early 1980’s. After the accident at three mile island, there were no nuclear power plants started in the U.S. for almost 34 years. Finally, in 2012 the Nuclear Regulatory Commission approved the building of 2 nuclear reactors in Georgia at Vogtle Generating Plant, and 2 nuclear reactors in South Carolina called Virgil Summer Nuclear Generating Station. Construction of nuclear reactors are notorious for cost overruns and construction delays. These projects have encountered numerous delays and significant cost overruns. Recently things got so bad Westinghouse (the firm constructing these nuclear reactors) declared bankruptcy because of these problems. The power companies that are having these projects built by Westinghouse are now confronted with a difficult decision. Should they try to complete the projects or should they abandon them? They have already sunk billions of dollars into these reactors, but the projected increase in costs may make completing the projects a very expensive proposition. We feel the most likely outcome is for the projects to be abandoned. Low gas prices have made gas-fired power plants a more attractive option for most utilities. Bondholders for these projects should be ok, as the sunk costs have already been passed on to the utilities’ customers through rate hikes. We feel this is a significant setback for the future of nuclear power in this country.
Foreign Buyers of Munis
There has been increased interest in taxable Muni bonds from overseas investors. One reason for the increase in foreign investing in Munis is the relatively high rates in the U.S. compared to other developed countries. Another reason is the safety of Munis compared to Corporate bonds. The default rates on an A-rated Muni are practically zero, while a similarly rated Corporate bond has a cumulative default rate over a 10-year period of about 2.5%. Finally, taxable Munis yield more than comparable Corporates. These factors combine to attract money from foreign investors into the Muni market.
We continue to believe we are in a low interest rate environment for a long period of time. Fed rate hikes against a weak economic backdrop may present investors with a good opportunity to add to their bond portfolios.