Bond Market Perspectives | Week of February 3, 2014

posted 2/6/2014 in Investments

Highlights:

  • Uncertainty over EM weakness and whether the weather is truly responsible for recent softness in economic data is likely to keep bond yields range-bound over the near term.

  • We believe the U.S. economy will resume the improvement that began in late 2013 and EM growing pains will not impact broader financial markets over the longer term.

  • We would use recent bond strength as a selling opportunity.


Developing Worries


Growing fears over weakness among developing, or emerging market (EM), countries continued to
lift Treasuries last week before weaker-than-expected economic data added to recent gains.

Among developed countries, US Treasuries are among the highest-yielding government bonds and became a destination for investors seeking to avoid EM turmoil. The yield differential between 10-year Treasuries and 10-year German Bunds, for example, exceeded 1.1% in late January, one of the widest yield disparities of the past 10 years [Figure 1].


EM concerns continued to drive high-quality bond prices higher despite several policy moves by EM central banks to stem the weakness. The central banks of Turkey, India, Brazil, and South Africa have all raised interest rates in recent days in an attempt to attract investment and stem currency weakness. In Turkey, aggressive central bank action has worked so far with the Turkish lira rising modestly last week. Unfortunately, interest rate hikes run the risk of further slowing EM economies.Slower-than-expected economic growth has been a key driver of EM asset underperformance in recent months, and recent rate increases may cause uncertainty over growth prospects to linger.

A disappointing Institute for Supply Management (ISM) report and weak auto sales for January,
both released on Monday, February 3, 2014, added to high-quality bond gains. The
weaker-than-expected economic data were a letdown for investors in 2014 after a strong second half of economic growth in 2013. The domestic data raised fears that an economic slowdown may be global in nature.


However, cold weather in January may have distorted the data. Regional manufacturing surveysfrom Dallas, New York, Philadelphia, Chicago, and Kansas City suggest the weakness of the national ISM may have been an outlier. Ford and General Motors stated publically that January auto sales were depressed because of the weather.


Range-Bound Yields Likely Near Term

Uncertainty over EM weakness and whether the weather is truly responsible for recent softness in
economic data is likely to keep bond yields range-bound over the near term. The 10-year Treasury
yield is approaching the low end of a six-month trading range after declining by a notable 0.38% in
January [Figure 2]. This yield range should remain intact until EM fears subside or domestic
economic data resume a stronger trend. Since weather-related distortions may continue to impact
near-term data, it may not be until early March that a clearer picture of the domestic economy
emerges.


Figure 2 illustrates the 2.5% yield level on the 10-year Treasury has been a significant barrier. Several high-quality bond rallies have been rebuffed over the past seven months once the yield on the benchmark 10-year Treasury has dropped to near 2.5%. We believe this yield barrier will hold once again absent signs that domestic weakness was not weather-related or that EM concerns translate into actual default threats.


Not 1998


Importantly, emerging markets have come a long way in the past 15 years, and today's conditions are far removed from those of the 1998 Asian crisis. The average yield advantage of broad emerging market bonds has increased but remains well below the double-digit levels of the late 1990s. The lower yield spreads reflect the development and economic improvement of developing economies.


The recent decline in EM bond prices and rise in yields reflect a pullback in response to
weaker-than-expected growth. Furthermore, developing markets remain small compared with their developed counterparts, and a change in investor appetites can have a dramatic impact on these less liquid markets. A rush to sell can drive prices more than perhaps justified by underlying economic conditions.


If bond investors believed greater risks were lurking, yields would be much higher on EM bonds than the current 5% average to compensate for potential default risks. The 5% average yield of EM bonds reflects the pullback in bond prices but is notably below the 9%-plus yields of the late 1990s and the Asian crisis [Figure 3]. The higher yields of the 1990s reflected not only a generally higher interest rate environment, but also a greater risk of default and credit concerns among EM investors.


Furthermore, in the late 1990s overnight lending rates in India, Turkey, and South Africa were well
into the double-digit range, and at or near 20% in the case of Turkey and South Africa. Such rates
were reflective of the much greater risks in EM economies at that time. Today's weakness must be
put in perspective.

Reliable Indicators Do Not Suggest Contagion


Signs that EM weakness is leading to global contagion remain elusive. As mentioned in last week's 
Bond Market Perspectives, the TED spread (obtained by subtracting the 3-month T-bill yield -- a
high-quality benchmark -- from the three-month Libor, a bank lending rate) remains near multi-year lows and is showing no signs of inter-bank lending fears. The TED spread has been a reliable early warning signal in recent years of bank lending fears, which in turn have led to more pronounced high-quality bond rallies and subsequent weakness in lower-rated bonds, such as bank loans and high-yield bonds.


Credit default swap (CDS) spreads also show no signs of contagion. CDS help institutional investors
to insure against the possibility of default. The greater the CDS spread, the greater the perceived
market risk of default, and therefore the higher the cost to insure against default. Among global
banks with greater EM exposure, such as Standard Chartered PLC, HSBC, and Banco Santander,
CDS spreads have increased in January but remain at roughly 50%, or less, of levels witnessed
during 2011 and 2012 when European debt fears were at their peaks.


A convergence of factors has led to a strong January in the bond market. The current yield range in the bond market may persist until further clarity arrives on domestic economic data and the extent of EM weakness. We believe the domestic economy will resume the improvement that began in late 2013 and EM growing pains will not impact broader financial markets over the longer term. We would use recent strength to trim sectors of the bond market that benefited most from a strong January.
 
 
 
 
IMPORTANT DISCLOSURES

The opinions voiced in this material are for general information only and are not intended to
provide specific advice or recommendations for any individual. To determine which investment(s)
may be appropriate for you, consult your financial advisor prior to investing. All performance
referenced is historical and is no guarantee of future results. All indexes are unmanaged and
cannot be invested into directly.


The economic forecasts set forth in the presentation may not develop as predicted and there can be no guarantee that strategies promoted will be successful.


Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values and yields
will decline as interest rates rise, and bonds are subject to availability and change in price.
Treasuries are marketable, fixed-interest U.S. government debt securities. Treasury bonds make
interest payments semi-annually, and the income that holders receive is only taxed at the federal
level.Government bonds and Treasury bills are guaranteed by the US government as to the timely
payment of principal and interest and, if held to maturity, offer a fixed rate of return and fixed
principal value.


International and emerging market investing involves special risks such as currency fluctuation
and political instability and may not be suitable for all investors.


Emerging market debt (EMD) is a term used to describe bonds issued by less developed countries.
This type of debt is primarily issued by sovereign (government) issuers, and may be denominated
in local currencies, or more heavily used currencies such as the Dollar or Euro.


Credit Quality is one of the principal criteria for judging the investment quality of a bond or bond
mutual fund. As the term implies, credit quality informs investors of a bond or bond portfolio's
credit worthiness, or risk of default.


Yield Spread is the difference between yields on differing debt instruments, calculated by deducting the yield of one instrument from another. The higher the yield spread, the greater the difference between the yields offered by each instrument. The spread can be measured between debt instruments of differing maturities, credit ratings and risk.


A Credit Default Swap (CDS) is designed to transfer the credit exposure of fixed income products
between parties. The buyer of a credit swap receives credit protection, whereas the seller of the
swap guarantees the credit worthiness of the product. By doing this, the risk of default is
transferred from the holder of the fixed income security to the seller of the swap.


The economic forecasts set forth in the presentation may not develop as predicted and there can be no guarantee that strategies promoted will be successful.


The Barclays Emerging Market US Dollar Denominated Hard Currency Bond Index is an
Emerging Markets debt benchmark that includes USD denominated debt from sovereign,
quasi-sovereign, and corporate EM issuers. The index is broad-based in its coverage by sector and
by country, and reflects the evolution of EM benchmarking from traditional sovereign bond indices
to Aggregate-style benchmarks that are more representative of the EM investment choice set.
Country eligibility and classification as an Emerging Market is rules-based and reviewed on an
annual basis using World Bank income group and International Monetary Fund (IMF) country
classifications. Bonds must be at least one-year to maturity or longer, be denominated in US
dollars, have an issue size of at least $500 million, and both investment-grade and high-yield
bonds are included.


This research material has been prepared by LPL Financial.


To the extent you are receiving investment advice from a separately registered independent
investment advisor, please note that LPL Financial is not an affiliate of and makes no
representation with respect to such entity.


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Tracking #1-243180 Exp. 02/15


The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly.
 
The financial consultants of Wealth Management are registered representatives with and Securities are offered through LPL Financial. Member FINRA/SIPC. Insurance products offered through LPL Financial or its licensed affiliates.
 
                                     Not FDIC/NCUA Insured Not Bank/Credit Union
                                                Guaranteed May Lose Value
                Not Insured by any Federal Government Agency Not a Bank Deposit 


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