Outlook on US Fixed Income 2012
It’s all about Government
Government and central bank actions continue to be the main drivers of financial markets, particularly fixed income. With the
announcement of open-ended quantitative easing (QE) in the United States and the European Central Bank (ECB) moving ahead
with its own plans for QE, the manipulation of capital markets continues. The leaders of both central banks have committed to
doing whatever is necessary to prevent deflation and the global economy from falling into depression. Clearly, the moves taken by
Ben Bernanke and Mario Draghi are unprecedented, and we are in uncharted territory in terms of the size and scope of central bank
intervention in capital markets. To put the ongoing intervention into perspective, the US Federal Reserve (the Fed) balance sheet is
currently about 20% of the US GDP, while the ECB balance sheet is now almost 30% of the euro zone’s GDP.1
The Impact of “QE Infinity”
The next round of QE in the United States has been given the moniker “QE Infinity” due to its open-ended nature. The Fed provided
no guidance in terms of limits to the program’s size or its expiration date. This was done for maximum impact and to prevent a market
reaction once the program ends. The Fed is now purchasing approximately $65–$70 billion a month in Agency mortgage-backed
securities (MBS); about $25–$30 billion of these purchases are maintaining the ongoing balance sheet exposure to prior Agency
MBS purchases and about $40 billion is tied to the newly announced program. By our estimation, the Fed now owns about 18% of
the existing US Agency mortgage market par outstanding. With no new net creations last year and negative net creations this year,
we expect the Fed to own approximately 30% of the market within one year if underlying conditions in the housing market remain
constant. With the recent program announcement, MBS spreads have collapsed to historic lows, with MBS option-adjusted yields for
many securities now basically equal to, or slightly lower than, Treasury yields based on our modeling of the prepayment option. While
we believe that security-specific opportunities remain in the Agency MBS sector, it is likely that we will be looking to rotate into other
investments with better risk-return attributes, as MBS spreads will likely continue to compress in the face of excessive government
In short, the Fed is causing valuation distortions that limit opportunities in the broad market to add value, while simultaneously
increasing the risks for negative outcomes in formerly safe-haven government securities. The main impact of these QE strategies on
fixed income markets has been to squeeze value from high-quality fixed income investments in an effort to move investors further out
on the risk spectrum. While the former has been materially accomplished, the latter has had limited success, as investment flows have
continued to favor high-quality fixed income segments due to lackluster macroeconomic conditions.
As we look toward the fourth quarter and the beginning of 2013, significant uncertainty remains over the US Presidential election, the
fiscal cliff, events in Europe, and overall economic growth. In that regard, not much has changed and there has been little clarity since
we issued our third quarter outlook. We have experienced more of the same in terms of financial repression and government interven-
tion in the markets. The latest round of QE was widely anticipated and, while we believe that the Fed has been largely successful in
attaining its four primary goals of low interest rates, low volatility of rates, low consumer borrowing rates, and ample liquidity, we
remain skeptical that the additional accommodative policies will in fact lead to the creation of real economic growth.
Currently, we believe that the Fed and Chairman Bernanke remain the only functioning financial components of the US federal
government, as most all other fiscal policy decisions are seemingly on hold until after the election. Without any visibility on the
fiscal policy side, we understand the Fed’s aggressive efforts to provide a floor for capital markets and stimulate consumer confidence.
However, regardless of whether or not we agree with the Fed’s actions, we need to remain focused on identifying the market opportuni-
ties and risks that exist under the framework of continued aggressive central bank intervention.
The State of the Market
Most of our fixed income strategies have similar outlooks and positioning: underweight in government securities, short duration rela-
tive to benchmarks, and a focus on opportunities in spread product. The general consensus is that many assets that are deemed “safe”
may indeed carry significant valuation and payment risks. We use the safety and comfort that many investors find in benchmark-hug-
ging strategies as an example. As there is the perception that indices are safe in times of uncertainty, it would make sense that investors
want to retreat to index exposures to avoid risk. The problem we find in utilizing this strategy is that the market index is no longer the
Exhibit 1 Exhibit 2
BofA Merrill Lynch US Domestic Master Index Duration BofA Merrill Lynch US Domestic Master Index Weight in US
and Yield Treasuries and US Treasuries Outstanding
(Years) (%) (%) $10,750 ($B)
45 40% 41% 12000
3.32% 5.25 35 31%
5 3 30 8000
3 1 Dec 08 Aug 09 Feb 10 Aug 10 Feb 11 Aug 11 Feb 12 Aug 12
Dec 08 Sep 09 Sep 10 Sep 11 Sep 12 US Treasuries in Index (LHS)
US Treasuries Outstanding (RHS)
As of August 31, 2012.
As of September 30, 2012.
Source: BofA Merrill Lynch, Securities Industry and Financial Markets Association
Source: BofA Merrill Lynch
same index. Over the past four years, fixed income index exposures have shifted quite dramatically. For example, based on our analytics at the end of
2008, the duration of the BofA Merrill Lynch US Domestic Master Index (an index that many managers believe reflects the core US fixed income
market) was 3.85 years, and the index yield was 3.32%. From the end of 2008 to September 30, 2012, the duration of the index rose by 36% to
5.25 years, while the yield declined by over 50% to 1.65%. This impact, as illustrated in Exhibit 1, means that an investor who mimics the index
has significantly increased their exposure to interest-rate risk in an environment defined by little marginal compensation to offset it. Furthermore,
the weight of US Treasuries in the index has risen from 23% at the end of 2008 to 41% in August 31, 2012, as shown in Exhibit 2. Those that
believe this index represents safety could be in for a surprise when the technical and governmental factors that are driving long-term interest rates
lower cease and market levels revert back to reflect fundamental investment factors.
Compounding the impact of these lower yields is investors’ continued demand for income. This demand has led to much less stringent covenants and
terms for all varieties of new fixed income issuance, increasing the market’s overall credit risk. In addition to this increased credit risk, interest rate risk
remains an even larger concern in an environment defined by direct government intervention and negative real yields. Based on the current histori-
cally low yield levels, we believe the risk for future interest-rate movements is to the upside. While we could see a technical rally in the bond market
where even lower yield levels are breached, from a purely fundamental standpoint, rates will eventually need to rise. If US 10-year Treasury rates were
to increase just 100 basis points from the 1.63% close on September 30, 2012, all other conditions being equal, we would likely have negative returns
that are unprecedented in the US investment-grade market. The impact would be very severe for strategies that favor long-duration securities.
Interestingly, despite the concerns outlined above that many fixed income managers share, investors seeking safety continue to move money into
the bond market. While we do believe that high-quality fixed income could be a safe haven to protect against equity market volatility, we think that
investors should be aware of what they own, as many perceived safety assets in the bond market have become very expensive in the current environ-
ment and may no longer offer the intended protection that is sought.
The main challenge we currently have as investors is finding rationally priced opportunities. Due to the unprecedented government intervention and
the near-panic buying of assets that are perceived as safe, we believe that many of the best opportunities in the fixed income market are in areas of the
market that are typically more analytically challenging with regard to accessing credit and/or option risks. These areas are generally relatively inexpen-
sive now, as they are less subject to the direct technical flows driving the broader markets. We strongly believe that returns in this environment will be
gained through thoughtful security selection. Not all credits are the same, and identifying the winners while avoiding the losers will be critical.
US High Yield
In the US marketplace, we still believe that higher-quality high yield is one of the more attractive asset classes. The non-distressed BB/B category
of the corporate bond market generally represents a healthy slice of US mid-cap corporations. Most of these companies have taken advantage of
market conditions and investor appetite for new issuance to refinance and recapitalize their balance sheets. The yields on many of these securities
are attractive and, through diligent research, we believe it is possible to limit credit events and capture excess carry. The key in this space is to limit
investments to those credits that have both the ability and willingness to pay back its debt obligations.
Outlook on US Fixed Income
US Municipal Bonds
We also continue to find opportunity in the municipal bond market. While we have been critical of the federal government in terms of trying to
solve the country’s fiscal problems, we do believe that many local authorities have been successful in attacking their budget problems. We are very
selective in the types of bonds we will own, focusing heavily on credit factors, such as covenants, economic conditions, and willingness to address
outstanding fiscal issues, so that we are assured we will receive interest and principal owed.
Another area of opportunity we have found in investment-grade corporates is essential financials. These are major financial institutions that are
critical to the functioning of the US economy. New financial regulations and capital reserve requirements have forced these firms to improve their
balance sheets and strengthen their ability to repay debt. We believe the negative headlines associated with these companies are more related to
their ability to generate shareholder gains on the equity side and, as bondholders, we feel that many of the companies in this category are stronger
and healthier today than they were pre-crisis. While we believed that many financials were overrated in 2007, we now believe that many are in fact
underrated and potentially attractive investments today.
Other Current Opportunities
While the situation around the globe is precarious, we believe opportunities in Europe exist. The bid on German bunds is strong, and the wide
differential between German and government bonds in peripheral European countries is concerning; however, these wide spreads do represent
potential opportunity if we believe that fiscal steps will be taken to help solve debt issues. A narrowing of this spread differential could have a large
impact on returns. As such, Yankee bonds of healthy companies that are domiciled in weak peripheral nations can be attractive, as they are typically
priced off the weaker sovereign. This again highlights opportunity away from perceived safety.
Currently, we estimate that US Treasury yields are depressed by about 50 basis points due solely to investors’ flight to safety. Given this estima-
tion, we believe any movement in 10-year US Treasury yields between current levels and 2.1% is really a trading range. We would not significantly
change our overall viewpoint regarding the health of financial markets until we see a breakout beyond this level. If we do see yields rise above this
level, the question will be whether it is due to deteriorating conditions and fear that the US government is going to be challenged in repaying
debt obligations, or whether it is due to economic strength and a flight away from fixed income into other riskier asset classes. These remain very
precarious times given the financial repression caused by the unprecedented intervention of developed market central banks and the high level of
uncertainty surrounding major macroeconomic events, such as the upcoming US elections and fiscal cliff. As high-quality fixed income investors,
we believe it is now most prudent to focus on security-specific analysis to find total return pockets of opportunity in the market.
1 ISI, as of September 27 2012.
Originally published on October 5, 2012. Revised and republished on October 10, 2012.
Past performance is not a reliable indicator of future results.
An investment in bonds carries risks. If interest rates rise, bond prices usually decline. The longer a bond’s maturity, the greater the impact a change in interest rates can have on its price. If you do
not hold a bond until maturity, you may experience a gain or loss when you sell. Bonds also carry the risk of default, which is the risk that the issuer is unable to make further income and principal
payments. Other risks, including inflation risk, call risk, and pre-payment risk, also apply. Securities in certain non-domestic countries may be less liquid, more volatile, and less subject to govern-
mental supervision than in one’s home market. The values of these securities may be affected by changes in currency rates, application of a country’s specific tax laws, changes in government
administration, and economic and monetary policy. High-yield securities (also referred to as “junk bonds”) inherently have a higher degree of market risk, default risk, and credit risk.
The securities identified are not necessarily held by Lazard Asset Management for all client portfolios, and should not be considered a recommendation or solicitation to purchase or sell these
securities. It should not be assumed that any of the referenced securities were or will prove to be profitable, or that the investment decisions we make in the future will be profitable or equal to
the investment performance of securities referenced herein.
This report is being provided for informational purposes only. It is not intended to be, and does not constitute, an offer to enter into any contract or investment agreement with respect to any
product offered by Lazard Asset Management, and shall not be considered as an offer or solicitation with respect to any product, security, or service in any jurisdiction or in any circumstances in
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by Lazard Asset Management to be reliable. Lazard makes no representation as to their accuracy or completeness. All opinions and estimates expressed herein are as of the published date, and
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