Schwab Bond Insights: New Tools?

by Rob Williams and Kathy A. Jones.

Rob Williams, Director of Income Planning, Schwab Center for Financial Research	Kathy A. Jones, Vice President, Fixed Income Strategist, Schwab Center for Financial Research

July 20, 2012

The Schwab Center for Financial Research presents Bond Insights, a bi-weekly analysis of the top stories in today’s bond markets. In this issue we reflect on the June FOMC meeting and what new tools they might be considering; a discussion on the murky economic outlook and what we think it means for the corporate bond market; our perspective on the situation in San Bernardino, CA and the historically infrequent event of bankruptcies in the muni world; and we take a look at Treasury Inflation Protected Securities (TIPS) and how they can be used to help hedge against inflation. 

New Tools?
The economic recovery is slowing—again. That’s the trend in recent data. The minutes from the Fed’s last meeting on June 19-20 indicate that the Fed is prepared to take further steps to boost the economy if growth falters. But interest rates are already at historic lows and further quantitative easing risks the potential to do more harm than good by igniting inflation without reducing unemployment. The Fed has mentioned the possibility of "new tools" that they might implement. What might the Fed do and when would they do it?

• Minutes of the June FOMC meeting indicate growing concern at the Fed about slower growth. Here's what we see as the key phrase from the minutes: "Most participants saw the incoming information as indicating somewhat slower growth in total demand, output, and employment over coming quarters." Total demand, output and employment are the major components of GDP—supply, demand and jobs. All that’s left are exports and government spending. The pace of exports has been slowing globally and it’s thought that the "fiscal cliff" will likely lead to a drop in government spending. Broad-based weakness in economic activity, high unemployment and subdued inflation may open the door to further easing.

• What new tools might they consider? The minutes also indicated that several members wanted to "explore the possibility of developing new tools to promote more accommodative financial conditions." Some of the potential policy options that have been mentioned by Fed officials in the past include lowering interest paid on bank reserves held at the Fed and extending the time frame when the committee expects to keep rates low beyond "late 2014" to signal the Fed’s commitment to low rates for even longer. There have also been suggestions that the Fed might target explicit levels of GDP growth and/or unemployment.

• In our view, there are drawbacks to all of these options. Lowering or eliminating the rate that the Fed pays on excess bank reserves might disrupt the short-term funding markets, without stimulating bank lending. Signaling changes in the Fed’s outlook could mean having to switch gears if the economy outperforms expectations or just be ineffective in changing the behavior of borrowers or lenders. Explicit growth and unemployment targets may be too hard to reach and lead to confusion and conflicts over the priority of the Fed’s concerns—inflation or growth.

• We expect the Fed to do something, nonetheless. If the economy looks like it is faltering in the second half of the year and unemployment remains stubbornly high, we still believe it is likely that the Fed will take some action. In his recent Congressional testimony July 17th, Fed Chairman Bernanke indicated that the Fed is "prepared to take further action as appropriate to promote a stronger economic recovery." Further quantitative easing—perhaps with a focus on buying mortgages—remains an option despite its potential drawbacks. 

• Timing depends on economic data. We won’t see preliminary second quarter GDP estimates until late July, but recent data suggest that growth may have slowed even from Q1’s sluggish 1.9% pace. Employment, manufacturing and retail sales figures have all shown softness in the past few months compared to earlier in the year and are significantly slower than late 2011. In addition, headwinds from Europe have intensified and growth is slowing in emerging markets, particularly China.

• Dates to watch, starting with July 31-August 1. Those are the dates for the next FOMC meeting. We don't expect that the Fed will add more easing at that meeting—they may want to wait for more data to assess the outlook for the second half of the year. The July 31-August 1 meeting doesn’t include a press conference or updated economic protections. The meeting that follows on September 12-13 does.

• Bottom line. We wouldn't be surprised to see further action if the data remain weak. We're not in the camp that sees the election in November as a deterrent to further Fed action. We think the Fed under Bernanke will do what they can if the economy remains soft and they think more stimulus will help.

Muddle Through—What Does it Mean for Credit?
Domestic economic data have been coming in weaker than expected, and the ongoing European debt crisis is weighing on the outlook for growth. With the economic outlook still murky, businesses continue to be on the defensive. Over the past few years, U.S. corporations have focused on strengthening their balance sheets. If domestic growth remains soft, and the U.S. economy continues to "muddle through," we believe the corporate bond market should remain an attractive source of income relative to Treasuries.

Corporate Cash Remains High as Debt Falls

Source: Schwab Center for Financial Research with data from Bloomberg, data as of July 16, 2012. Data is from all companies in the S&P 500 Index. Total debt is in dollars per share.

• Corporate bonds are still the best house in a bad neighborhood, in our opinion. Since the Great Recession, corporations have been busy cleaning up their balance sheets. Cash and cash equivalents of S&P 500 companies have steadily risen, while debt has decreased markedly. As of the first quarter of 2012, corporations, on average, held about $293 per share in cash on their balance sheets, compared to $152 ten years ago. Likewise, total debt/share has decreased to $778, compared to its peak of $1295 in the first quarter of 2008. Treasury rates remain at historically-low levels, and companies have taken advantage by refinancing much of their higher-coupon debt. The average coupon of the Barclays US Corporate Bond Index (representing the investment grade market) has dropped for three straight years, currently sitting at 5.2%.

• Have earnings peaked? We won't know the answer to this for another quarter or two, but we believe that the answer will not have much of an impact on the corporate bond market. Despite record low financing rates, companies have been reluctant to increase their debt loads as market uncertainty remains. Meanwhile, investor demand for corporate bonds has been increasing as investors search for yield. We think strong demand and limited supply should continue to keep the corporate bond market supported.

• Corporate yields still look attractive to us in relative terms. In absolute terms, yields aren't that attractive. The average yield on the investment grade bond index hit an all-time low on July 16, with a yield to maturity of 3.1%. However, the spread, or yield above a comparable Treasury yield, is still wider than its long-term average. Investment grade yield spreads currently sit at 1.9%, compared to the 20-year average of 1.4%, while the Barclays U.S. Corporate High-Yield Bond Index spread of 6.1% is above its 20-year average of 5.3%. Despite the overall low yield, spreads could compress further.

• Corporate bonds have become more "credit-sensitive" than "interest-rate sensitive." Prior to the financial crisis a few years ago, corporate bonds tended to be highly correlated to the Treasury market, meaning their performance generally tracked together. For 15 years leading up to the crisis, corporate bond performance was tied more to the changing interest rate environment than credit concerns, except during periods of economic contraction. This has changed over the past few years. When looking at rolling 5-year correlations, corporate bonds have become much less correlated with Treasuries than in the past. The market appears to track more closely with credit quality now, and less with interest rate changes.

• Bottom line. If the economy continues to muddle through, we believe that the investment grade corporate market will continue to be relatively attractive compared to the Treasury market. While slower growth may have a negative affect on the equity market, we think the relative strength of corporate balance sheets overall should allow the corporate bond market to withstand market disruptions, without a significant rise in default rates. Yield spreads may continue to be volatile, but we believe the risk of a large spike in spreads is fairly low. We continue to favor intermediate-term investment grade bonds, with a focus on the 5- to 7-year maturity range.

Next Exit—San Bernardino
San Bernardino, CA is modestly famous for its inclusion in the song "Get Your Kicks on Route 66" and as one of several cities to say that they're home to the first McDonald’s. Now it may be the third city in California to file for chapter 9 bankruptcy protection this year. The emphasis is still on "may." The city council may be reconsidering that decision, made last week. According to news reports today, the city council wants to "collect more information" before filing. While San Bernardino may add to a short list of city, town and county bankruptcies, the impact so far to municipal investors overall has been limited.

• Bankruptcies so far remain relatively infrequent events. If San Bernardino follows Stockton into chapter 9 bankruptcy protection, and the filing is found legal by the state of California and court, it’ll become the 45th bankruptcy filing for a city, town, or county, since 1981, according to Bloomberg. Of those, 33 were dismissed by a judge. And no city, town or county since the Depression, according to recent Bloomberg reports and legal analysts have used bankruptcy to reduce or not pay principal to bondholders.

• Defaults remain isolated to more speculative sectors. Recent news stories point to Stockton, CA as the first city, town or county ever to seek to reduce payments to bondholders as part of a bankruptcy filing. Bond payments, for most municipalities, have not been the primary cause of distress and were not generally reduced or eliminated in bankruptcy. Stockton is one of the first cities to say that they'd like to use bankruptcy to reduce payments, including potentially principal, to bondholders. They already ceased payments on debt that relies on general government revenue. This includes bonds backed by city leases—called lease-revenue bonds—and bonds issued to pay city pensions—called pension obligation bonds. The precedent to watch will be to see if a court allows Stockton to reduce principal owed on these bonds.

• There's been little reaction in the California or national market. Most muni watchers are well aware of the challenges and rise in distress and even bankruptcy. But there has been little reaction in the market overall, as investors seek tax-exempt yield of relatively high quality. The fact that the market has continued to rise isn’t a signal to buy, in our opinion. But it’s a rough indication of the muted response in muni markets.

• Still, for individual investors, credit analysis has become even more important. Given the relatively low historical frequency of defaults in the market for investment-grade muni bonds, credit analysis may have been an after-thought for many investors. Defaults have been far lower than for corporate bonds with similar ratings, and virtually non-existent for true general obligation bonds and revenue bonds from highly-rated essential services such as water and sewer systems. While we expect that defaults or distress for higher-rated municipalities will remain isolated, credit analysis may be even more important long-term.

• The challenge in both short- and long-term. There are more than 20,000 city governments in the U.S. Each is being impacted by economic challenges differently. The housing bust in cities like Stockton and San Bernardino has reduced tax revenues while the ability to raise property taxes or other revenues for local governments in California are limited by state law. So we’ve seen a concentration of challenges in California over the past few months. The bigger challenge nationally is longer term, in our view, as states and municipalities continue to balance existing resources (i.e. tax revenues) with need to provide basic services, but also manage benefits and other employment costs.

• Bottom line. Although municipalities face significant challenges, bankruptcies remain relatively infrequent events in the world of muni bonds. They have not generally led to non-payment of principal on bonds. We expect they'll remain the exception, and so far there’s been little impact on markets overall. To help reduce the risk of issue-specific events, consider using mutual funds or professional managers or, for individual bonds, focus on highly rated issuers in areas with stronger economies. For help, talk with a Schwab fixed income specialist at 877-563-7818.

Less than Zero—TIPS vs. Treasuries
Negative real yields abound in the fixed income markets. Central banks around the world have reduced short-term interest rates to historic lows, pulling longer-term bond yields lower as well. Real interest rates—nominal yields minus the inflation rate—are negative for all US Treasury bonds maturing in ten years or less. So, investors seeking a safe haven in the Treasury market from credit risk are faced with watching their principal erode over time after inflation is taken into account. Treasury Inflation Protected Securities (TIPS) offer an alternative for risk-averse savers. But yields on TIPS are negative. What should you consider when choosing between the two?

• What's your inflation outlook? A choice between Treasuries and TIPS depends on your outlook for inflation. The current rate of inflation, measured by CPI is 1.7%, but the average over the past five years has been 2.3% and the Fed has targeted a sustainable inflation rate of 2% for the personal consumption expenditures (PCE) deflator.

Real Yields Remain Less than Zero

Source: Schwab Center for Financial Research with data from Bloomberg, data as of July 17, 2012. "Real" Treasury yields represent the nominal yield minus the current inflation rate of 1.7%.

• TIPS basics. TIPS are indexed to the overall CPI. The principal value increases with inflation and decreases with deflation. At maturity, you receive either the adjusted principal or the par value, whichever is greater. Interest is paid twice a year at a fixed rate, and the interest rate is applied to the adjusted principal. Consequently, interest payments rise and fall with inflation as well.

• Nominal Treasury yields are below the rate of inflation for maturities up to ten years. Conversely, even when purchased at negative yields, TIPS can still produce positive returns if inflation remains at the current level. The total return moves up if inflation rises to the Fed’s 2% target rate or back to the 2.3% long-term average over the next few years. The real return on nominal Treasuries would decline. 

• Compare the Breakeven Rates. You can compare the rates offered by TIPS to those offered by Treasuries by looking at the "break even" rate. The breakeven rate is the difference between the Treasury yield and the TIPS yield of comparable maturity. The following are calculations for the breakeven rates for two-, five- and ten-year TIPS as of July 17, 2012:  

Breakeven Rate Calculations

Note: The current annual yields for the two-year, five-year and ten-year Treasury securities are 0.24%, 0.62% and 1.51% respectively. To gain a positive real return on Treasuries, we would need to see much lower rates of inflation or deflation. Conversely, TIPS could produce a positive return in real terms, albeit a small one.
Source: Bloomberg data from July 17, 2012. Annualized total returns assume TIPS securities are held to maturity, with a 0.26% reinvestment rate.

If you buy ten-year TIPS, your return should be higher than the return on a nominal 10-year Treasury bond if the inflation rate averages more than 2.08% over the next ten years. If inflation averages less than 2.08%, then your return will lag the return on Treasuries. Therefore, when the breakeven rate rises, TIPS are more expensive relative to Treasuries and vice versa. Recently, breakeven rates have fallen along with the inflation rate. After peaking in the spring, breakeven rates for TIPS have declined along with the CPI. Therefore, if you believe that inflation is likely to rise over the next ten years, then TIPS may be a better choice than nominal Treasuries. If you expect inflation to decline, then nominal Treasuries would be a better choice, all else being equal.

5- and 10-Year TIPS Breakeven Rates 

Source: Bloomberg data from July 17, 2012.

• A caveat. TIPS are bonds and therefore are still subject to interest rate risk. TIPS don't protect against a rise in interest rates stemming from stronger growth or higher demand for loans. In other words, if interest rates move up faster than the rate of inflation, then TIPS may still lose value. For example, if the economy strengthens and demand for loans picks up faster than inflation, then interest rates may move up faster than inflation. So, TIPS can provide inflation protection but not interest rate protection. In this scenario, of course, Treasury bond prices would also decline.

• Bottom line. For savers with very low risk tolerance and concern about inflation, TIPS may make sense as an alternative to nominal Treasuries in the current environment, even with negative yields.

 

Important Disclosures
For funds, investors should carefully consider information contained in the prospectus, including investment objectives, risks, charges and expenses. You can request a prospectus by calling Schwab at 800-435-4000. Please read the prospectus carefully before investing.

Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed income investments are subject to various other risks including changes in credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications and other factors.

Income from tax-free bonds may be subject to the Alternative Minimum Tax (AMT), and capital appreciation from discounted bonds may be subject to state or local taxes. Capital gains are not exempt from federal income tax.

Lower-rated securities are subject to greater credit risk, default risk and liquidity risk.

This report is for informational purposes only and is not an offer, solicitation or recommendation that any particular investor should purchase or sell any particular security or pursue a particular investment strategy. The types of securities mentioned herein may not be suitable for everyone. Each investor needs to review a security transaction for his or her own particular situation.

All expressions of opinion are subject to change without notice in reaction to shifting market conditions. We believe the information obtained from third-party sources to be reliable, but neither Schwab nor its affiliates guarantee its accuracy, timeliness, or completeness.

Past performance is no guarantee of future results.

Diversification strategies do not assure a profit and do not protect against losses in declining markets.

Examples provided are for illustrative purposes only and not intended to be reflective of results you should expect to attain.

Treasury Inflation Protected Securities (TIPS) are inflation-linked securities issued by the US Government whose principal value is adjusted periodically in accordance with the rise and fall in the inflation rate. Thus, the dividend amount payable is also impacted by variations in the inflation rate as it is based upon the principal value of the bond. It may fluctuate up or down. Repayment at maturity is guaranteed by the US Government and may be adjusted for inflation to become the greater of the original face amount at issuance or that face amount plus an adjustment for inflation.

Barclays Municipal Bond Index consists of a broad selection of investment- grade general obligation and revenue bonds of maturities ranging from one year to 30 years. It is an unmanaged index representative of the tax- exempt bond market.

Barclays U.S. Corporate Bond Index covers the USD-denominated, investment grade, fixed-rate, taxable corporate and non-corporate bond markets. Securities are included if rated investment-grade (Baa3/BBB-/BBB-) or higher using the middle rating of Moody's, S&P, and Fitch.

Barclays U.S. Corporate High-Yield Bond Index the covers the USD-denominated, non-investment grade, fixed-rate, taxable corporate bond market.. Securities are classified as high-yield if the middle rating of Moody’s, Fitch, and S&P is Ba1/BB+/BB+ or below.

Barclays U.S. Treasury Index includes public obligations of the U.S. Treasury excluding Treasury Bills and U.S. Treasury TIPS. Securities have USD250 million minimum par amount outstanding and at least one year until final maturity. Subindices based on maturity are inclusive of lower bounds. Intermediate maturity bands include bonds with maturities of 1 to 9.9999 years. Long maturity bands include maturities 10 years and greater.

Barclays U.S. Treasury Inflation-Protected Securities (TIPS) Index is a market value-weighted index that tracks inflation-protected securities issued by the U.S. Treasury. To prevent the erosion of purchasing power, TIPS are indexed to the non-seasonally adjusted Consumer Price Index for All Urban Consumers, or the CPI-U (CPI).

S&P 500® Index is a market-capitalization weighted index that consists of 500 widely traded stocks chosen for market size, liquidity, and industry group representation.

Indexes are unmanaged, do not incur management fees, costs and expenses and cannot be invested in directly.

The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.