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Schwab Bond Insights: New Tools?
by Rob Williams and
Kathy A. Jones.
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.
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.
Through—What Does it Mean for Credit?
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.
Cash Remains High as Debt Falls
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
- 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.
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
than Zero—TIPS vs. Treasuries
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
Yields Remain Less than Zero
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:
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.
and 10-Year TIPS Breakeven Rates
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.
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
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.
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
Past performance is
no guarantee of future results.
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
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
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).
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.