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Fixed-Income Insights

Here's a look at how changes in the supply of new and existing securities could affect performance of key segments of the fixed-income market.

 In Brief

Supply factors could influence the performance of key segments of the fixed-income market in 2014, including:

  • Treasuries—The tapering of monthly bond purchases by the Federal Reserve will likely counteract the expected reduction in net supply of government debt.
  • High yield—Issuance of high-yield bonds and floating-rate loans likely will decline in 2014, even as demand from yield-hungry investors increases.
  • Municipals—Issuance of municipal securities may register a 13-year low in 2014, with the resultant reduction in the supply potentially helping to stabilize the muni market.
  • Emerging markets—The supply of emerging-market corporate bonds is not expected to decline in 2014, while issuance of dollar-denominated bonds by emerging-market governments may actually increase over the issuance in 2013.
  • The key takeaway—Supply considerations likely will differ across fixed-income segments, but, overall, the case for emphasizing shorter maturities and lower credit quality remains intact.

 

The Federal Reserve's focus on gradually reducing its monthly purchases of $85 billion of mortgage-related securities and long-term U.S. Treasuries has caused particular concern about the price of long-term, high-quality bonds. One factor informing the market's concern is that since the Fed's current round of quantitative easing (QE) began in September 2012, the central bank's aggressive bond-purchase program has reduced the available supply of mortgage-backed securities and longer-dated Treasuries in the market. This reduced supply, of course, has been a factor in higher Treasury prices, and the attendant reduction in yields.

But the Treasury market isn’t the only corner of fixed income facing questions of changes in the supply/demand equation; the high-yield, emerging market, and municipal segments also will be influenced, to varying degrees. Let’s take a look at the supply questions for these segments of fixed-income—and the implications for investors.

Treasury Market
While investors may be heartened to read headlines highlighting lower borrowing levels by the U.S. government in 2014, that reduction is likely to provide little support for Treasury bond prices. The expected reduction in net supply of $119 billion is laudable, but will be quickly overwhelmed by the reduction in purchases by the Fed referenced above.

Fed tapering, assuming that the current reduction of $10 billion per month holds, will lower total Fed purchases by $150 billion by May 2014 and $445 billion by September. Ignoring the reduction in mortgage-related securities, the Fed will have reduced Treasury purchases by $140 billion through July and $225 billion through September, easily offsetting the $119 billion reduction in supply.

Furthermore, there is a maturity mismatch between the reduction in U.S. borrowing and the reduction in Fed purchases. The $119 billion reduction in borrowing is likely to be proportionate to the existing borrowing schedule, meaning that most of that reduction will take place in securities with maturities of five years or less. The Fed’s QE is focused exclusively on maturities of six years and longer, reinforcing the expectation that lack of Fed purchases is likely to produce lower prices and higher yields among longer-term Treasuries. If anything, the reduction in U.S. borrowing may accentuate a steeper yield curve (i.e., a larger yield increase between short maturities, such as two-year Treasuries and longer maturities, such as 10-year Treasuries), reinforcing the fixed-income strategy of reducing maturity during a period of rising rates among longer maturities.

High Yield
In addition to potential investor interest in avoiding interest rate volatility and capturing higher yield, there may be yet another advantage to high-yield securities during 2014: there may be a reduced amount of them available in the market. High-yield issuance nearly topped $400 billion in 2013, while the amount of similar quality bank loans brought to market was about $670 billion, according to JP Morgan. Issuance in both categories will likely decline in 2014, as many companies have already taken advantage of low interest rates to issue new debt or refinance outstanding obligations. JP Morgan forecasts that 2014 issuance of high-yield debt and bank loans will decline, to $300 billion and $400 billion, respectively. This total of $700 billion in gross financing for 2014 represents only 65% of the $1.070 trillion issued in 2013.

Last year, investor interest in high-yield securities and bank loans was sufficient enough to bid up prices of such debt in an environment of falling prices among longer-maturity Treasuries. A continuation of that "search for yield" mentality in 2014 could produce similar demand for higher-yielding, rate-insensitive fixed income at a time when substantially fewer bonds may be available for purchase.

While the combination of potential investor interest in higher-yielding bonds, the historical interest rate insensitivity of such securities, and the reduction in new issuance suggests great support for the high-yield and bank-loan asset classes, the resulting demand could raise concern in the market. Surprisingly, the biggest worry is not the narrow yield spreads between high-yield asset classes and underlying Treasuries. Given the current low incidence of default and the low absolute yield of Treasuries, the spread differentials of high-yield debt and bank loans, while not historically attractive, still remain at least 100 basis points above the multiyear lows of 2006–07.

Instead, the biggest concern that could develop from increased demand is the underwriting strength that investor demand conveys to the issuer. Bank-loan issuers already have taken advantage of strong demand to reduce covenant protection. Demand for high-yield debt has led to short call structures (for example, bonds callable in three years instead of five years) that are offset by higher-than-usual first call premiums (say, a call price of 103 instead of 100 or 101). Additional demand in 2014 could lead to a more pronounced issuer-friendly environment in which thorough analysis and understanding of structure is as vital to the investment decision as familiarity with company management and the stress testing of financial projections.

Thus, while a supply/demand imbalance in 2014 may support prices of lower-quality debt, it also seems likely to augment the value of experienced credit analysis and portfolio management in constructing a portfolio that can distinguish between securities likely to outperform and those that could fall short of investor expectations.

Municipals
Reduced supply in municipal securities in 2014 also could help support prices in that market. Severe redemptions by retail investors in the second half of 2013 pressed municipal bond prices lower. At year-end, the resulting higher yields were similar to and, in some cases, higher than comparable corporate issues. As investors weigh the impact of higher marginal state and federal taxes, which in some states exceed 50%, and the additional 3.8% Medicare tax on investment income, municipals could appear relatively attractive, if not cheap. With potentially less risk of additional headline shocks, such as occurred in Detroit and Puerto Rico, the municipal market could turn toward stability in 2014.

Investors who want to take advantage of lower prices and relatively attractive yields also may take some comfort in the expectation that 2014 muni issuance may register a 13-year low, resulting in a reduction in the supply of available muni securities after consideration of maturing debt and refinancings. As with the high-yield and bank loan sectors, a reduction in supply could support investors who purchase municipals in 2014.

Emerging-Market Debt
In contrast to the high-yield and muni segments, the supply of emerging-market (EM) corporate bonds is not expected to decline in 2014, while issuance of dollar-denominated bonds by EM governments may actually expand by 20% over issuance in 2013, according to Barclays Research. While such supply could pressure prices lower in an asset class that logged relatively poor performance in 2013, investors' search for yield could reverse 2013 outflows from EM bond funds, supporting demand for the sector.

Once again, security selection is likely to be vital to performance in 2014 as emerging-market economies exhibit less correlation among themselves. Those EM countries with internal growth, controlled inflation, and adequate foreign-exchange resources will likely fare better than those with export-dependency, rising inflation, and declining currencies. Indeed, much of the additional supply may come from the latter category if these nations' foreign currency reserves are inadequate. The additional supply in the emerging market segment could adversely affect some issues, while leaving stronger credits unscathed.

Conclusion
Changes in supply may not dominate the performance of different fixed-income classes in 2014, but they seem to reinforce strategies that Lord Abbett has endorsed. The strategy of avoiding long-term, high-quality debt by reducing maturities seems supported by the combination of Fed tapering and a mild reduction in Treasury borrowing, which together should promote a steeper yield curve. Exposure to high-yield bonds or bank loans, assuming investors are comfortable with credit risk, seems supported by a reduction in supply in both those categories. Municipals, which seem to offer attractive relative value after significant investor selling in 2013, may benefit from reduced supply, assuming a resumption of investor interest at current levels. Emerging markets now seem particularly subject to a variety of cross-currents, including supply, which could adversely affect some countries, while having little impact on others.

Throughout the fixed-income universe in 2014, new issuance of securities will affect some sectors more than others during the year. More important, investors may wish to avail themselves of the enhanced access to that supply—and the analytical discipline used to select securities in those sectors—that professional management can provide.

 

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