Many on Wall Street and elsewhere have been predicting higher interest rates and lower bond prices for years. They’ve consistently been wrong. This article from The Financial Times summarizes their worst calls and argues that perhaps all the missed calls have made bond investors too complacent. Perhaps bond yields finally might rise more than expected.
Wall Street’s forecasting toolkit for Treasuries has proved consistently too pessimistic, eroding the confidence of all but the grizzliest bears.
“The market has been looking for higher yields for a long time and getting beaten up on it,” says Harvinder Sian, head of G10 rates strategy at Citigroup. At the start of the year, the consensus forecast put the year-end yield at 2.8 per cent. Instead the drop in yields has generated a total return of 5 per cent for the Barclays 10-year Treasury index so far this year.
I’ve been following the peer-to-peer lending organizations for a while. These are groups that find individuals and small businesses that want to borrow money, conduct some due diligence on them, and offer pieces of the loans as investments to individual investors. You don’t have to be a “qualified investor” required of hedge fund and private equity investments. The organizations are touted as a way for small investors to earn higher yields.
I’ve been waiting for the next recession to see how the loans offered by these groups perform. But it didn’t take that long for a major controversy to occur. The largest of the groups, The Lending Club, made headlines recently when its CEO was forced to resign amid allegations of conflicts of interest and lack of transparency. Here’s a story from Bloomberg.com which argues that these anti-Wall Street organizations were taken over by Wall Street firms.
At the NYSE, Samberg suggested an opportunity to profit while powering LendingClub. He later introduced Mack to Andrew Hallowell, head of Arcadia Funds LLC, a Burlington, Massachusetts, manager of investment funds. The key would be a hedge fund-like partnership that invested in LendingClub loans, Cirrix Capital, whose potential beneficiaries would include Mack and Laplanche, according to a person familiar with the matter.
If all went well, Cirrix would be lucrative for the inside investors. Mack and Laplanche are in a class of limited partners who, at the end of each quarter, collect a 4 percent annualized return before profits are shared with general partners, regulatory filings show. After that, they get 80 percent of remaining gains, according to a March 2016 filing. Other benefits available to limited partners included lower advisory fees. Hallowell didn’t respond to messages seeking comment.
Meb Faber has a provocative post in which he argues that people shouldn’t like stocks that pay dividends. He doesn’t make the overvaluation case that’s made frequently these days. Instead, he makes a long-term case against dividends. He doesn’t like that dividends are taxed each year, whether you need the income or not.
We ran two estimates with real historical tax rates at the lowest and highest tax brackets, and found that the benefit of avoiding dividend stocks ranged from an after tax bump of 0.3 to over 3 percentage points PER YEAR.
Many investors, including retirees, value those dividend checks they receive every quarter. But this research reveals that those dividend checks carry a huge opportunity cost. Your “bird in the hand,” so to speak, is costing you about three or four in the bush.
MLPs focused on the energy industry suffered a great deal when the price of oil dropped. Most analysts believe the drop was excessive, because MLP profits don’t depend on the price of oil or gas. The MLPs provide facilities such as pipelines and storage tanks for fees that are independent of the price of energy. They also generally have long-term contracts. But this article explains the next threat to MLPs. The energy companies could file for bankruptcy and use bankruptcy to break their contracts with the MLPs. But the attorneys writing the article contend that the arguments for breaking the contracts are weak, so MLPs shouldn’t have as much at risk as some fear.
This argument seemed a strong one. However, after examining the applicable Texas property law at issue, on March 8, 2016, Judge Chapman issued a non-binding bench ruling holding that the legal requirements for treating these arrangements as real property interests were not satisfied and that they could be invalidated in bankruptcy through the contract rejection process.
This ruling rocked the midstream world. It also came when similar attempts to reject gathering agreements were underway in the Quicksilver Resources and Magnum Hunter Resources bankruptcy cases in Delaware, leading to a sense that the midstream industry was under assault.
As the midstream industry braced itself for more adverse rulings, many companies in the sector began examining their gathering contracts and asking how certain highly technical provisions in such contracts would be treated in light of Sabine.
Long-term treasury bonds have had a good year as interest rates declined. But is it the end of the road for lower rates? The team at Wasatch-Hoisington U.S. Government Bond doesn’t think so. In this article from Bloomberg.com, they explain their outlook.
Founded in 1980 by Van Hoisington, the firm tends to buy long-term Treasuries when he and Lacy Hunt, who’s helped guide investments since 1996, predict inflation is in a long-term cycle of decline. They switch into mostly cash-equivalent securities when they have the opposite outlook. For now, the former approach is holding sway, with inflation below the Federal Reserve’s target since 2012. While a market-based measure of inflation expectations for the next five years is near the highest since July, it’s still well below its 10-year average. The biggest risk for longer maturities is that inflation quickens and erodes the value of coupon and principal payments.
“We do not believe the secular low in rates is at hand,” said Hunt, who began his career in 1969 as an economist at the Federal Reserve Bank of Dallas.“The economy is weak and inflation is contained, and as long as that continues we will make our mistakes from being on the long side of the Treasury market.”
This Bloomberg.com article interviews several of the top high-yield fund managers about their current assessments of the market. The top manager of the last decade is optimistic. He believes the recent sell off and concerns about a recession are unwarranted. Others aren’t as optimistic. But none of the managers recommends across the board buying in high-yield bonds. They all advise cautious buying in companies and sectors.
Top bond managers have divergent views on the high-yield bond market, which slumped to more than a two year low in February before rebounding as job growth accelerated. DoubleLine Capital’s Bonnie Baha warned last week that China’s weakening economy might inflict more pain on junk-bond investors. Notkin is more bullish, expecting mid-to-high single-digit returns this year, while Pimco’s Mark Kiesel sees buying opportunities.
“The market is as attractive as it has been in four or five years,” Kiesel, chief investment officer for global credit at Pacific Investment Management Co., said in an interview last week. Pimco favors bonds in industries tied to the strength of the U.S. economy, including housing, he said in an e-mail Tuesday.
Energy master limited partnerships have had a tough time the last couple of years. Their share prices declined with the price of oil, though theoretically the price of oil shouldn’t affect them. Now, a bankruptcy court case could put one of the underpinnings of many MLPs at risk. An energy company has asked a bankruptcy court judge to let the firm out of its contracts with an MLP. A major selling point of MLPs as investments is that long-term service contracts lock in a stream of revenue, regardless of what happens to the price of oil. If the judge agrees with the firm, the reliability of MLP revenues could be at risk.
The problem isn’t a judge will unilaterally slash the rate the Chesapeakes of the world pay pipelines to move their hydrocarbons to market, as is often reported. Bankruptcy judges can’t do that, any more than they can force a supplier to sell raw materials for less to a company in reorganization.
A judge might be able to do something almost as bad, however. Many companies financed the expansion of their gathering networks to the wellhead by signing contracts with producers that not only guaranteed a certain flow of molecules through the system, but prohibited producers from shipping with anybody else.
The arguments can become a bit technical. The issue is why are real interest rates (nominal rates minus inflation) so low, and also why is the riskless rate of return so low. This post links to an academic article that surveys the drop in real rates in recent years and attributes it to several causes. Most importantly, the authors believe the causes will persist, keeping real rates low. That also should lead to low returns for other assets.
Moreover, most of these forces look set to persist and some may even build further. This suggests that the global neutral rate may remain low and perhaps settle at (or slightly below) 1% in the medium to long run. If true, this will have widespread implications for policymakers — not least in how to manage the business cycle if monetary policy is frequently constrained by the zero lower bound.
Energy master limited partnerships have taken a beating over the last year. In theory, they shouldn’t be hurt by declining oil prices, because the energy services they provide are compensated for flat fees independent of the price of oil. Some analysts say recent prices are a good buying opportunity, and yields are 10% or higher. But an article in this week’s Barron’s (subscription might be required) says there is more pain to come in MLPs. The analyst who forecast today’s problems in MLPs back when all the other analysts were positive says most MLPs have too much debt, have overinvested in infrastructure, and engage in aggressive accounting. He also says they face a long-term downturn in energy production, rising competition, and the risk that the energy firms with which they contract will fail to meet their obligations. He believes we’re in the early phase of the MLP downturn.
“For MLPs to be more compelling investments, the sector has to absorb more pain, and that pain has to come in the form of distribution reductions,” he tells Barron’s. (Distributions are the MLP form of dividends.) “That’s the way the sector is going to solve its leverage problem. Cutting distributions is the right decision for an overleveraged industry entering a downturn.” MLPs are loath to cut distributions because investors, mostly retail buyers, prize those payouts and punish companies that cut them.
Kaiser is coming off his biggest coup, following Kinder Morgan’s surprise move in December to slash its once-sacred dividend by 75%. Its stock, at $15, is down 60% in the past year. Barron’s has been bearish on both Kinder Morgan (ticker: KMI), the leading energy pipeline company, and Linn (LINE). Kaiser’s comments and analysis have figured in our articles on them.
Treasury bonds have done quite well, and high-yield bonds have lost value in recent months. In between are investment-grade corporate bonds. They’ve appreciated some. Recent trends, however, are being interpreted differently by analysts. This article in The Wall Street Journal (subscription might be required) says that some hedge funds are betting against investment-grade bonds now. They believe that the problems in energy and commodities will spread to other sectors of the economy. But this article says that now is a good time to to buy investment-grade bonds. Their yields are at their highest spread to treasury bond yields since the European debt crisis. That’s not because corporate bond prospects are deteriorating, it says, but because treasury yields have declined so much. For now, I’m staying with treasury bonds and letting the recent trends play out a little longer.
The current spread between IG bonds and Treasuries is pricing in an extremely negative outcome. At roughly 200 basis points above the Treasuries, IG bonds are either an attractive asset class or a very large canary in the dungeon of a coal mine that will presage a global recession.
If IG bonds are a decent buying opportunity (properly sized and risk-managed and at longer maturities), it is due to the compression of the U.S. Treasury curve. That is, the reason for the spread widening between bonds and Treasuries is because of curve flattening, not because IG bonds now contain an embedded, previously unknown, asset class risk.