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The world is a simpler place when you do not have to worry about things like credit risk. The world is a simpler place when you do not have to worry about interest rate risk.

Our World Has Changed

June 17th, 2020 by Kurt L. Smith
  • Most of us come to realize that change is inevitable and adapting to change is a part of life. Sometimes change is like aging in front of a mirror:  it isn’t until you look back several years that you realize, yes, I have changed…I mean aged.

    This, of course, is not what I am talking about. Today we have a sea change (literally), as well as one massive change after another. The world has changed and adapting to it will be key to our survival.

    My focus here is on the bond market, which just happens to be the primary tool of our monetary authorities: The Federal Reserve and the central banks of the world.  Fiscal authorities are also joining the bond rush as governments issue bonds to finance their response to our changed world.

    The fundamental change that happened in the bond market occurred in early March and was the subject of my April letter. US Treasury securities traded at yields of 0.70% and lower across all maturities from a few days out to the longest thirty-year maturity per Bloomberg. This extremely low (or no) yield means longer term bond prices were at their highest prices ever as the price of the bond includes, effectively, almost all of the income you would receive in the days, years or even decades to come for the bond.

    But it is not just treasury bonds. Other bonds such as mortgages, corporates and municipals also benefitted by the high bond prices as the yield spread on those bonds in early March were at or near historical lows. Historically low spreads, together with the low (no) yields of the treasury base means bond prices on almost all bonds were their highest prices ever.

    Why would one continue to own a twenty year non-callable corporate or any other type of bond if the market is willing to pay you essentially all the cash you will ever receive on it up front, today? This is not a theoretical discussion about low/no interest rates; this is what happened in March 2020.

    This is a market, here the bond market, and what we experienced, together, was a massive topping in bond prices after bottoming almost forty years ago in the early 1980s. The markets, of course, continue to move and what we have seen since the March top is an initial plunge in bond prices, followed by a strong upward correction. We have seen our economy shut down as well as reopen. We have seen stocks tumble, only to skyrocket higher. This is how markets function.

    What is different about bonds is that there is only so much cash the bond can possibly pay you. It is why bonds are called fixed income.  For noncallable US treasury bonds you know when and how much interest it will pay you as well as the maturity amount.  Add all the cash flows up and the difference between the sum of your cash flows and the market price in early March is not that much different at less than 0.70% yield.  That high pricing also assumes certainty that those cash payments will be made and made on time, which here is zero credit risk or no risk of default.

    Before March, low yields and low spreads (highest prices) reflected essentially no risk of default. Why worry about being paid back, or better yet, how could you worry if you just purchased a twenty-year bond at just over 1%? Sure, the purchase of the bond may entail risk, but do you want the bond or not?  Low yields are what the market offered.  Now, however, the world has changed and so have spreads. There is risk in bonds and coming from a measure of no risk with historically low spreads, I am willing to say risk only gets greater from here.

    The world is a simpler place when you do not have to worry about things like credit risk. The world is a simpler place when you do not have to worry about interest rate risk. In fact, there is a huge contingent of my investment brethren who continue to believe, and let me emphasize the word believe, credit risk and interest rate risk continue to be close to nonexistent. Those investment professionals foist the power and actions of the Federal Reserve as the reason not to worry.

    Our world however has changed. Let the Federal Reserve buy all the low (no) yielding and highest priced bonds they want. Better the Fed than you and I. No investor, in my opinion, should continue to own low (no) yielding high priced bonds as bonds have reached their destination in terms of performance, in my opinion. That was the point of my April letter. The world is not returning to normal.  When was normal anyway? The world has changed.

    The same concepts of low yield, low spreads and resulting high asset prices are not just a bond market phenomenon. The phenomenon is or was present in all asset classes. This if course does not bode well for prices in those asset classes as the tide of risk appears to be rising.

    Cash may yield little to nothing, but you know you have an alternative.  The phenomenon of low yields and low spreads may return if longer-term treasury yields go lower than 0.70% and historically low spreads go even lower.  If so, investors may get a tick higher price on their bond portfolios than the one they saw in early March.  My advice is to let the Federal Reserve and their followers gorge on all the high-priced bonds they want.  We know the world has changed and risks exit. We also prefer yield over high-priced bonds.

    City of College Station, TX

    Certificates of Obligation

    Aa1 Moody’s Underlying AA+ S&P Underlying

    Due 2/15 Dated 7/13/20 Maturity 2/15/40

    $21,055,000 Sold

    1            2021          5.00%           0.28%

     2            2022          5.00%           0.33%

     3            2023          5.00%           0.36%

     4            2024          5.00%           0.42%

     5            2025          5.00%           0.52%

     6            2026          5.00%           0.67%

     7            2027          5.00%           0.82%

     8            2028          5.00%           0.90%

     9            2029          5.00%           1.00%

     10          2030**      5.00%           1.10%

     11          2031**      5.00%           1.16%

     12          2032**      3.00%           1.57%

     13          2033**      3.00%           1.62%

     14          2034**      3.00%           1.70%

     15          2035**      2.00%           2.04%

     16          2036**      2.00%           2.09%

     17          2037**      2.00%           2.12%

     18          2038**      2.00%           2.17%

     19          2039**      2.125%        2.21%

     20          2040**      2.125%         2.25%

    * Yield to Worst (Call or Maturity) ** Call 2/15/29

    Source: Bloomberg

    This is an example of a new issue priced the week of 6/16/20

    Prices, yield and availability subject to change

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