Second Quarter 2010 GTAA Fixed Income

8/9/2019 Second Quarter 2010 GTAA Fixed Income

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GTAAFixed Income

March 26 th , 2010

Damien Cleusix

Clue6 Second Quarter 2010

am en c ue .com



1Executive Summary

Fixed IncomeGovernment bonds are not a bubble. They might not be a good B&H investment but they are behaving rationally and will beeven more highly correlated to nominal GDP growth than in the past... Yields will resume their secular downtrend when leadingindicators turn down and new credit stress reappears. In the meantime, expect some crowding out if/when private creditdemands reaper.

On the inflation/deflation debate we remains on the potential inflation scare (but not reality except in some emerging markets) in- , .

words and acts will be needed as there remain a risk that they will try to inflate the problems away more quickly than anticipated(but as you know we believe this will be more actual after the next down leg… they seem to confident now…).

Cor orate and Emer in market bonds s reads have continued to ti hten but are showin some si ns of fati ue. While

spreads are not yet too low for our comfort (even is their a getting closer by the day, yields are. Both high yield and emergingmarkets bonds are yielding less today than at the high of the credit bubble in 2007 . Beware…

Sentiment analysis is supportive for government bonds with survey indicating too much bearishness while commercials havea big net long position on the 30 years contract and non reportable an important net short position. Smart-money is increasingits exposure to treasuries while they are lowering their corporate and high yield exposure. We are still seeing smalldiscounts and even premium on High yields close end funds. They are typical of tops. In the meantime, High yield andinvestment grade ETFs are trading with a 1-3% premium.

On the liquidity side, banks and public demand should be more than sufficient to absorb public issuance, for now. Refinancingneeds at the high yield corporate, banks and emerging market side are likely to pose a much greater risk . While manyemerging markets are in much better shape than 10-15 years ago, they still remain dependant on flows from the US, Europe andJapan. Furthermore never underestimate the power of crowd dynamic in this area of the market. Stress in Eastern Europe or




2Executive Summary

even inside the EU will have dramatic domino effects… This will provide a fantastic buying opportunities. If you have to belong or if you can do relative value, favor operating leveraged against financially leveraged countries.

Seasonality is slowly getting more supportive for bonds while we will soon enter the negative season for more risky bonds.

The trend of the US and UK government bonds markets is up (for yields) but yields are at/approaching crucial resistance. .

Corporate and emerging market bonds trends are still rising but the momentum is slowly fading away with some notabledivergences appearing. We would strongly advise to exit on any sign of trend change.

Avoid the most risky bonds in both categories. sometimes less yield is better.




3Bonds: Valuations – A RepeatChart 1We still do not think that government bonds are a bubble. They are clearly a poor long-term

investment (Chart 1) but they are behaving rationally given the nominal growth prospect. Yieldswill continue to follow the ebb and flows of leading indicators but 10 years yield will declinemuch below 2% before we have a real inflation scarce… this is what we have predicted sincethe autumn of 2007 and see no real reason to chan e this forecast.

earsReturn Forecast

There will be a time when one will have to worry about inflation as government spendingcontinue to grow and new stimuli will have to be voted in the next few years but we are still

in a deflationary environment whose existence will become apparent when the economyslow a ain and commodities decline.

The huge pick up in the monetary base has not resulted in an increase of credit (moneymultiplier collapsing). Capacity utilization is historically low, wages should continue todecline,…

Emerging market and corporate bonds relative investment value has continued to diminishfollowing the biggest 12 months rally in history. CSFB estimates that at current spread levels,US high yield CDX indices discount 25% cumulative default rates with a 20% recoveryrate (Table 1)(53% in March 2009). The peak 5 years cumulative default rates in the past 100years were 46% in the 30s, 35% in 1991 and 36% in 2002 and we currently are at 23%.

High Yield DefaultAssumptionTable 1

Source: GMO

We have spent the past few years documenting the deterioration of the aggregate companiesbalance sheets, lax lending standards (no covenant,…) which has resulted in a very, very high

level of very poor companies papers (CCC as a % of total emission set records).

We are seeing some markers of the credit bubble reappear with cov lite, pig toggles anddividend recaps bonds being sold in the past 4-5 months .

This could lead to some bad surprises, and not only on the recovery front (we won’t come back on the fact that the CDS market will potentially increase bankruptcies as hedged bond Source: CSFB


holders will prefer a rapid liquidation than months of uncertainties , the fact that DIPfinancing is scarce despite the huge rally…



4Bonds: Default – History

Chart 3Chart 2 Moody’s US High Yield Default Rate Moody’s US Investment Grade Default Rate

Source: SG Credit Research, Moody’sSource: SG Credit Research, Moody’s

Chart 2 and 3 are not up to date with the recent big increase absent form both graphs (12-13% default in the US and 8-9% in Europe for high yield).

Both Moody’s and Standard & Poors are predicting rapidly declining default rate by the end of the year . While the might be right for 2010their expectation of low default rate in 2011 and forward is going to be wrong… …




5Bonds: SentimentUS 10 Years Treasur Yields and Greenwich Macro

Chart 5Chart 4 TLT and Conference Board Interest Rate Survey

Managers Bond Sentiment

A net 40% of people surveyed by The Conference Board are expecting rates to rise in the next 12 months (Chart 4). As one can see they were

Source: Van Mac Group, Clue6Source: Bloomberg, Clue6

.consider it bullish for government bonds in the current environment.

Macro Managers are , according to VanMac Group, rather positive on government bonds with less than 30% bearish opinion (Chart 5). It doesnot yet qualify as an extreme opinion but is moving closer (note that when we get an extreme it pays to follow their opinion).




6Bonds: SentimentJP Mor an Treasur Investor all

Chart 7Chart 6 ML Fund Managers Survey on US Bonds

Clients Net Long Survey

Source: Merrill Lynch

More than 60% of the fund managers polled by Merrill Lynch are expecting long-term rates to be higher in 12 months while almost 80% are

Source: Bloomberg, Clue6

expec ng s or - erm ra es o e g er ar .

JP Morgan Treasury Investor Sentiment all Clients Net long survey (% net long - % net short) is indicating the most pessimism since 2007 (Chart 7).

Note that the clients surveyed have been more often right than wrong at turning points…




7Bonds: SentimentUS 10 Years Treasur Yields and Tbonds Commercials US 10 Years Treasur Yields and 10 Years Tresur s

Chart 9Chart 8

and Non Reportable Net Future Position

Commercials and Non Reportable Net Future Position

Commercials have been increasing their Tbonds net long positions during the past few months (Chart 8). They have historically been the smart

Source: Bloomberg, Clue6Source: Bloomberg, Clue6

. .

Both Commercials and Non Reportable are long the 10 years contract (Chart 9). The steep yield curve has a high explanatory power here.Yields have had a tendency to start meaningful decline when both have switched from a net long to net short position.




8Bonds: Sentiment – Smart MoneyUS Government Bonds 10 + Total Return and Wasatch- ML Hi h Yield Master II and Loomis Sa les

Chart 11Chart 10

Hoisington US Treasury Beta Exposure

Institutional High Income Beta Exposure

There are many good bond investors but there are 2 which consistency has always fascinated us .

Source: Clue6Source: Clue6

On Chart 10 one can see that V. Hoisington has recently dramatically increased its exposure to the US long bonds after having decreased it a lotsat the end of 2008.

D. Fuss has recently started to decrease its exposure to the high yield markets (Chart 11).




9Bonds: LiquidityGovernment Bonds as a Percenta e of Commercial

Chart 13Chart 12 10 Years Treasury and Yield Curve

Banks Total Assets

There are many investors worrying about who will be left buying the bonds issued by the US Treasury (and others finance ministries around the

Source: Bloomberg, Clue6Source: Federal Reserve, Clue6

. -2.5x the public one in the US) but there are potentially huge pool of demand.

Commercial banks will probably increase dramatically their Treasury investment (Chart 12), both because they will have to (new regulations)and because they will us the carry between long and short rate to build up capital at low risk (Chart 13).


This is what happened in Japan and in other countries (US included) in past similar configuration.



10Bonds: LiquidityChart 15Chart 14 ICI Bond Mutual Fund Assets and Net Cash FlowUS Households Net Buying of Treasuries

Household will also continue to reallocate toward fixed income investment as we demonstrated in 2007 (Chart 14) … Only 7-8% of their assets arein fixed income securities… Retiring boomers will see more attraction in stable cash flows as opposed to capital gains (and they haven't

Source: ICI, Clue6Source: Federal Reserve, Clue6

...

Fixed income mutual fund buying (Chart 15) has been concentrated in the corporate bonds mutual funds… demand is slowly moving towardgovernment bonds now that yields have been rising and corporate spreads declined…


,

2007…). This is 1% above the 2001 and 2004 highs… and this will let managers continue to buy even if they do not get fresh money…



11Bonds: Liquidity

Source: Mirae Asset Management

If we take the 1989-1994 cycle has a model, the private domestic sector should buy usd 6.3 tn. Until the end of 2013, more than the usd 5.5 tn.budget deficit projected… and we believe that they will buy substantially more…

Something to keep an eye on in the short/medium-term is a potential resurgence of private sector credit demand. The stock private sector credit is


. - …



12Bonds: LiquidityChart 17Chart 16 US TIC Data10 Years Treasuries and Bids

What about foreign demand.

When buying treasury bonds, foreigners have three main variables to consider. First the level of the yields, then the relative valorization of the USD and finally the

Source: Bloomberg, Clue6Source: Clue6

n at on prospects.

US long yields are higher than in Europe and Japan while the currency is significantly undervalued. Remains the inflation variable… The Fed has been somehow more aggressivethan the ECB and the treasuries has put a lot of guarantees everywhere which are likely to end up being very costly but the next phase of the economic stress might be centered inEurope and as such the ECB will have to be aggressive too…


e ast a ternat ve s t e creat on o arger on mar ets n var ous emerg ng mar et reg ons… t s w appen ut s ow y so no rea n uence or now…

Note that foreigners have been net sellers of corporate and Agency bonds (Chart 17).



13Bonds: LiquidityChart 19Chart 18 Bonds Funds Net FlowsBonds Funds Net Flows

Source: Lipper/AMGSource: Lipper/AMG

Looking at net inflows into bond funds, one can see that foreign bonds are very popular (Chart 18-19) (another sign of extreme negativism towardthe USD).

Note the huge inflows into bank loans and emerging market bonds . They both had net inflows of more than 13% of AUM… year to date!Excess, excess…




14Bonds: LiquidityEmer in Markets Bonds uarterl BondUS uarterl Hi h Yield Bond

Chart 21Chart 20

Issuance (US bn.)

Issuance (US bn.)

And guess what… both high yield (Chart 20) and emerging markets (Chart 21) bond issuance has been rising rapidly in the past few months.

Source: Bloomberg, Clue6Source: Bloomberg, Clue6

Investors want paper, they get it .

Our guess is that investors will regret their thirst for yield… down the road…




15Bonds: Liquidity – RefinancingChart 23Chart 22 US High Yield and Leveraged Loans Maturity Schedule EUR High Yield and Leveraged Loans Maturity Schedule

Source: BarclaysSource: Barclays

… . , ,leveraged loans (Chart 22 and 23), financials,…

Almost 70% of the US high yield market will mature by the end of 2014.




16Bonds: Liquidity – RefinancingChart 25Chart 24 g e on a ur y

Schedule: Current vs. Historicaleverage oan a ur y c e u e:

Current vs. Historical

Source: MLSource: ML

We have also noted that the maturity length has been declining in the past 5-6 years, notably in the leveraged loan sector.

This can be clearly seen on the chart 24 and 25.




17Bonds: Liquidity – RefinancingChart 27Chart 26 Europe Bonds Net Issuance Calendar Eastern Europe External Flows

As one can see, the refinancing issue is not limited to corporate but also sovereign bonds.

Source: IMFSource: MS

Where will the money come from? We do not know… Expect higher real yields, higher spreads and much more bankruptcies than currentlydiscounted by the market.

This is going to be THE ISSUE in the next 2-3 years … and remember that government can not afford this inevitable crises…We will have time to


write muc more a out t is issue later…



18Bonds: Seasonality-

Chart 29Chart 28 US high Yield Bonds TR Seasonality (since 1990)-

Seasonality (since 1986)

Government bonds have the inverse seasonal pattern of the stock markets (Chart 28) and are approaching the end of their weak season …

Source: Clue6Source: Clue6

High yield bonds seasonality pattern is similar as the stock market (Chart 29)




19Bonds: Intermarket

10 Years yield have a tendency to fall when 5 year forward 5 year real yield rise above 2.5%. We are not far…




20Bonds: Sovereign

Source: M. Reinhart and K. Rogoff

We have insisted a lot in the recent past on the prospect of sovereign distress down the road …

Banking crisis are expected to be followed by debt crisis with a lag as the fiscal costs ultimately overwhelm the capacity of affected countries torepay their foreign owned debt.


So be prepared for sovereign stress to emerge… and don’t chase yields where risks are too high. The most successful investors are those who donot lose money.



21Bonds: SovereignFiscal Imbalance as a

Chart 30Table 2 US Government Debt to GDP Ratio

Percentage of GDP (2004)

“It is not the towering sail, but the unseen wind that moves the ship”.

Source: Measuring the Unfunded Obligations of European Countries J. Gokhale Source: Federal Reserve, Clue6

Don’t be fooled, when the public realize that they will never get what they have been promised, behaviors will change … and this is not goingto be good for growth and risky assets.

On chart 30 one can see a debt to GDP ratio for the US including state and local debt and GSE debt (if you want to know why the GSE are included,


… .



22Bonds: DemographicChart 31 10 Years Treasury Yields and Demography

Source: Emphase Finance

We will write more a out t is in t e future ut suffice to say t at purely emograp ic mo els are not favora le for on yiel s…

The proportion of retirees will rise faster than those saving a lot…








25Bonds: GraphsUS 10 Years Government Bond Yield

We are slightly long but

3.8.We would start buying

again on a move toward3.95-4.1.

The 10 years yields continue to hover just below the 4-4.3 all important resistance. There are no real trend and yields are still lowerthan in June 2009.

A move above 3.8 would see a potential acceleration toward the red resistance area where we could become aggressive buyer.




26Bonds: GraphsEuro 10 Years Government Bond Yield

ShoulderShoulder

Head

We are long.

We would exit someon a move above 3.2.

Breaking down from a potential H&S formation with a target of 2.7-2.8.


, .



27Bonds: GraphsUK 10 Years Government Bond Yield

We are watching.

The resistance area rejected the February up move.

We have said since 2007 that the UK would face a very serious fiscal crisis which would potentially need the intervention of theIMF. We still believe it. Let’s see how it copes with a rapidly falling residential real estate market in the next 6-24 months.




28Bonds: GraphsiShares iBoxx High Yield Corporate Bond Fund (HYG)

We would exiteventual long position

at those levels.

Moody’s BAA Yields

he trend s st up but has deter orated. o se has h stor ca y been ow n th s mar et. rend o ow ng, even us ng short-term parameters, wor ssuperbly.

But do not forget that while spreads have yet to reach historic lows, absolute yields have started to reach secular lows . According toMoody’s the US Baa bonds are yielding 6% which is not far from the 5.8% low reached in 2005 and below where they were in 2007.


Do you feel you are compensated for the risks developed earlier in the current quarterly? Well we think not… so if you want to follow the trend,be disciplined and respect sell signals.



Bonds: Graphs 29

iShares JP Morgan USD Emerging Mar ets Bond Fund (HYG)

ML Emerging MarketsSovereign Plus Yields

We would exiteventual long positionat those levels.

To a new all time high… and with spreads which are not sufficient to cover the risks… We can only repeat:

“We would prefer to have the Eastern Europe crisis behind us before being more constructive on High Yield Sovereign bonds.

We will be active and profit from the usual “baby is thrown with the bath water” pattern when panic sets in.


Avoid countries with trade deficit and high foreign capital needs (as an high loan to deposit).”



30Bonds: Conclusion

Government bonds are not a bubble. They might not be a good B&H investment but they are behaving rationally and will be even more highlycorrelated to nominal GDP growth than in the past... Yields will resume their secular downtrend when leading indicators turn down and new creditstress reappears. In the meantime, expect some crowding out if/when private credit demands reaper.

On the inflation/deflation debate we remains on the potential inflation scare (but not reality except in some emerging markets) in the very short-term,deflation then and inflation further down the road. But careful analysis of government and Central Banks words and acts will be needed as thereremain a risk that they will try to inflate the problems away more quickly than anticipated (but as you know we believe this will be more actual afterthe next down leg… they seem to confident now…).

Corporate and Emerging market bonds spreads have continued to tighten but are showing some signs of fatigue. While spreads are not yet toolow for our comfort (even is their a getting closer by the day, yields are. Both high yield and emerging markets bonds are yielding less today thanat the high of the credit bubble in 2007 . Beware…

Sentiment analysis is supportive for government bonds with survey indicating too much bearishness while commercials have a big net longposition on the 30 years contract and non reportable an important net short position. Smart-money is increasing its exposure to treasuries whilethey are lowering their corporate and high yield exposure. We are still seeing small discounts and even premium on High yields close end funds.They are typical of tops. In the meantime, High yield and investment grade ETFs are trading with a 1-3% premium.

On the liquidity side, banks and public demand should be more than sufficient to absorb public issuance, for now. Refinancing needs at the highyield corporate, banks and emerging market side are likely to pose a much greater risk . While many emerging markets are in much better shapethan 10-15 years ago, they still remain dependant on flows from the US, Europe and Japan. Furthermore never underestimate the power of crowddynamic in this area of the market. Stress in Eastern Europe or even inside the EU will have dramatic domino effects… This will provide a fantastic

uying opportunities. If you ave to e long or if you can o relative value, favor operating leveraged against financially leveraged countries.

Seasonality is slowly getting more supportive for bonds while we will soon enter the negative season for more risky bonds.


d



31Bonds: Conclusion

The trend of the US and UK government bonds markets is up (for yields) but yields are at/approaching crucial resistance area where we expectields to be re ected. In Euro e the trend is une uivocall down .

Corporate and emerging market bonds trends are still rising but the momentum is slowly fading away with some notable divergences appearing.We would strongly advise to exit on any sign of trend change.

Avoid the most risk bonds in both cate ories. sometimes less ield is better.


Documents

Second Quarter 2010 GTAA Fixed Income