FIXED INCOME STRATEGIES FOR LATE 2017 NAVIGATING UNCHARTERED TERRITORY, RISING RATES, AND YOUR FIXED INCOME PORTFOLIO

Transcription

1 FIXED INCOME STRATEGIES FOR LATE 2017 NAVIGATING UNCHARTERED TERRITORY, RISING RATES, AND YOUR FIXED INCOME PORTFOLIO

2 1 The information contained herein reflects the views of Galliard Capital Management, Inc. and sources believed to be reliable by Galliard as of the date of publication. No representation or warranty is made concerning the accuracy of any data and there is no guarantee that any projection, opinion, or forecast herein will be realized. The views expressed may change at any time subsequent to the date of publication. This publication is for information purposes only; it is not investment advice or a recommendation for a particular security strategy or investment product. Graphs and tables are for illustrative purposes only.

3 TITLE/ INTRO

4 RISK POOLS ARE NOT CREATED EQUAL Similarly aligned belief shared with AGRiP constant collaboration on a formal and informal basis leads to better results More than 215 different pools with different liabilities, investment objectives/goals, and guidelines Pools vary widely in policies and practices, members served, financial measures and metrics, and operational structures; investment structure is not a one size fits all solution Understanding Risk Pooling structures, statutes/legislation, regulations, investment policies, and investment guidance from Pool Executives and Staff is vital 3

5 REBOUNDING FROM THE CREDIT CRISIS

6 LONG PERIOD OF EXPANSION SINCE CRISIS, ALTHOUGH ONLY MODERATE GROWTH POST CRISIS GDP GROWTH GDP (%) 5% 4% 3% 2% 1% 0% Post Crisis Average GDP (Sept 2009 June 2017): 2.2% Post War Average GDP (June 1947 June 2017): 3.2% 1% 2% 3% 4% Output Gap GDP YoY 70 Year Average GDP Post Crisis Average GDP Entering our 9 th year of economic expansion Persistent output gap, with post crisis GDP growth 1% below 70 year average 5 Source: Bloomberg; as of 6/30/17

7 FULLY RECOVERED LABOR MARKET, ALTHOUGH LIMITED WAGE GAINS & LOW PARTICIPATION UNEMPLOYMENT RATE LABOR FORCE PARTICIPATION RATE 11% 67% Unemployment Rate (%) 10% 9% 8% 7% 6% 5% 4% 3% 2% Labor Force Participation Rate (%) 66% 65% 64% 63% 62% 61% 60% Unemployment Rate Labor Force Participation Rate 6 Unemployment rate has fully recovered to precrisis levels At 4.4%, the labor market is generally considered to be at/near full employment Labor force participation has declined to 40 year lows Source: Bloomberg; as of 8/31/17

8 FULLY RECOVERED LABOR MARKET, ALTHOUGH LIMITED WAGE GAINS & LOW PARTICIPATION AVERAGE HOURLY EARNINGS YEAR OVER YEAR % CHANGE 4.0% 3.5% 3.0% 2.5% 2.0% 1.5% 1.0% % Change in Average Hourly Earnings Wage growth has improved in recent years, as unemployment finally fell below 5% 7 Source: Bloomberg; as of 6/30/17

9 INFLATION PERSISTENTLY BELOW FED S TARGET, MARKET EXPECTS TO REMAIN BELOW TARGET CORE CONSUMER PRICES & CORE PCE YEAR OVER YEAR % 2.5% 2.0% 1.5% 1.0% 0.5% PCE Core Price Index YoY Fed's Inflation Target Inflation has been running consistently below the Fed s 2% target level TIPS breakevens are pricing in sub 2% inflation for the next 10 years 8 Source: Bloomberg; as of 7/31/17

10 LOW RATE ENVIRONMENT A GLOBAL STORY, NOT JUST U.S. GLOBAL CENTRAL BANK BALANCE SHEET $20 $20tn $15 $15tn Assets $10 $10tn $5 $5tn $ FED ECB BOJ $4.5 $5.1 $4.5 Global central banks used quantitative easing as an additional monetary policy tool $15 trillion would be equivalent to nearly 40% of the total U.S. fixed income market 9 Source: Bloomberg; as of 8/31/17

11 LOW RATE ENVIRONMENT A GLOBAL STORY, NOT JUST U.S. GLOBAL 10 YEAR GOVERNMENT BOND YIELDS 6% 5% 4% Yield 3% 2% U.S. 1% 0% 1% US 10 Yr UK 10 Yr France 10 Yr Germany 10 Yr Japan 10 Yr Low rates are the norm globally U.S. Government bond rates are the highest in the developed world 10 Source: Bloomberg; as of 8/31/17

12 ECONOMIC EXPECTATION ECONOMIC EXPECTATION GDP growth and inflation to be above recent levels Wage gains Low energy prices fully reflected Do not expect a return to historical 3% + growth New normal/secular stagnation Aging of the workforce Lower population growth Weaker productivity gains Potential for 3% growth, but only for short periods of time Fiscal policy Unsustainable long term 11

13 EXPECT CONTINUED MODERATE GROWTH & INFLATION FOMC MEDIAN YEAR END FUNDS RATE PROJECTIONS (%) 3.0% Year end Fed Funds Rate 2.5% 2.0% 1.5% 1.0% 0.5% 0.0% Long Term Market Expectations (1M OIS FWD) Fed 9/20/17 Meeting Market remains skeptical of the Fed s rate forecast Fed has consistently lowered their future rates expectations over time 12 Source: Bloomberg; as of 9/20/17

14 MARKET RALLY CONTINUES

15 ASSET CLASS RETURNS 10 YEARS LATER REBOUNDING FROM THE CREDIT CRISIS Emerging Markets 28.62% Commodities 16.23% Int'l Stocks 11.17% Gov't Treasury 9.81% Intermediate Bonds 6.97% Large Cap 5.49% Gov't Treasury 24.03% Int'l Bonds 7.98% Intermediate Bonds 5.24% Cash 1.80% High Yield 26.16% Small Cap 33.79% High Yield 58.21% Emerging Markets 58.04% Int' Stocks 31.78% Real Estate 28.46% Small Cap 27.17% Large Cap 26.46% Real Estate 28.07% Small Cap 26.85% Commodities 16.83% High Yield 15.12% Large Cap 15.06% Emerging Markets 12.56% Gov't Treasury 29.93% Real Estate 9.37% Intermediate Bonds 7.84% High Yield 4.98% Int'l Bonds 4.47% Large Cap 2.11% Int'l Stocks 17.32% Real Estate 17.12% Small Cap 16.35% Emerging Markets 16.24% Large Cap 16.00% High Yield 15.81% Small Cap 38.82% Large Cap 32.39% Int'l Stocks 22.78% Emerging Markets 14.73% High Yield 7.44% Int'l Bonds 1.39% Real Estate 32.00% Gov't Treasury 25.07% Large Cap 13.69% Int'l Bonds 9.90% Intermediate Bonds 5.97% Small Cap 4.89% Real Estate 4.48% Int'l Bonds 1.68% Large Cap 1.38% Intermediate Bonds 0.55% Cash 0.03% Int'l Stocks 0.81% Small Cap 21.31% High Yield 17.13% Large Cap 11.96% Commodities 11.77% Emerging Markets 9.54% Real Estate 6.68% Int'l Bonds 5.05% Commodities 35.65% Commodities 18.91% Gov't Treasury 9.38% Cash 0.08% Int'l Bonds 5.26% Real Estate 1.22% High Yield 2.45% Gov't Treasury 1.21% Int'l Bonds 5.46% Cash 4.74% High Yield 1.87% Small Cap 1.57% Real Estate 17.55% Large Cap 37.00% Real Estate 39.20% Int'l Stocks 43.38% Emerging Markets 48.58% Intermediate Bonds 5.93% Int'l Bonds 2.26% Cash 0.16% Gov't Treasury 12.92% Int'l Stocks 7.75% Intermediate Bonds 6.54% Int'l Bonds 3.44% Cash 0.13% Small Cap 4.18% Int'l Stocks 12.14% Emerging Markets 12.82% Commodities 13.32% Intermediate Bonds 4.22% Gov't Treasury 3.56% Cash 0.07% Commodities 1.06% Cash 0.05% Intermediate Bonds 2.02% Commodities 9.52% Gov't Treasury 12.66% Cash 0.03% Int'l Stocks 4.90% Emerging Markets 9.19% Commodities 17.01% Small Cap 4.41% High Yield 4.47% Emerging Markets 10.18% Commodities 24.66% Intermediate Bonds 2.65% Gov't Treasury 1.33% Int'l Stocks 1.00% Cash 0.27% 14 Source: evestment; as of 12/31/16

16 FIXED INCOME SECTOR RETURNS EVEN WITHIN FIXED INCOME, ALL SECTORS AREN T CREATED EQUAL TIPS 11.63% Treasury 11.35% High Yield 58.21% CMBS 20.40% TIPS 13.56% High Yield 15.81% High Yield 7.44% Municipals 9.05% Municipals 3.30% High Yield 17.13% Treasury 8.83% MBS 8.34% CMBS 28.45% High Yield 15.12% Municipals 10.70% IG Corporates 9.82% CMBS 0.23% IG Corporates 7.46% MBS 1.51% IG Corporates 6.11% MBS 6.90% TIPS 2.35% ABS 24.72% IG Corporates 9.00% IG Corporates 8.15% CMBS 9.66% ABS 0.27% MBS 6.08% ABS 1.25% TIPS 4.69% CMBS 5.57% Municipals 2.47% IG Corporates 18.68% TIPS 6.31% Treasury 6.57% TIPS 6.98% Treasury 1.34% CMBS 3.86% Treasury 1.18% CMBS 3.32% IG Corporates 4.56% IG Corporates 4.94% Municipals 12.91% ABS 5.85% MBS 6.23% Municipals 6.78% MBS 1.41% TIPS 3.64% CMBS 0.97% ABS 2.03% Municipals 3.36% ABS 12.72% TIPS 11.41% MBS 5.37% CMBS 6.02% ABS 3.66% IG Corporates 1.53% Treasury 2.57% IG Corporates 0.68% MBS 1.67% ABS 2.21% CMBS 20.52% MBS 5.89% Treasury 5.29% ABS 5.14% MBS 2.59% Municipals 2.55% High Yield 2.45% TIPS 1.44% Treasury 1.06% High Yield 1.87% High Yield 26.16% Treasury 1.41% Municipals 2.38% High Yield 4.98% Treasury 1.71% TIPS 8.61% ABS 1.88% High Yield 4.47% Municipals 0.25% 15 Source: evestment; as of 12/31/16

17 LONG TERM RETURNS FOR EQUITIES & FIXED INCOME SIMILAR, BUT ACHIEVED IN DIFFERENT WAYS BARCLAYS U.S. LONG TREASURY & S&P 500 TOTAL RETURNS 50% 40% 30% 20% 10% 0% 10% 20% 30% 40% 50% Bloomberg Barclays U.S. Long Treasury S&P 500 Average Accommodative Global Central Banks, low rates, low inflation, modest growth has encouraged a risk on appetite Stock and bond returns have performed well over the past 25 years; however, they have exhibited strong negative correlation during this time period (correlation = 0.53) Interestingly, stocks and bonds have not both been negative during any calendar year since Source: evestment; as of 12/31/16

18 HISTORICAL BULL & BEAR MARKETS S&P 500 HISTORICAL BULL & BEAR MARKETS 600% Cumulative Returns 500% 400% 300% 200% 100% 0% Bull 2.6 Yrs 74% Bull 6.2 Yrs 126% Bear 1.7 Yrs Bull 5.0Yrs 229% Bear 0.3 Yrs Bull 12.3 Yrs 582% Bear 1.5 Yrs Bull 0.3 Yrs 21% Bear 0.5 Yrs Bull 5.2 Yrs 96% Bear 1.1 Yrs Bull 0.1 Yrs 24% Bear 0.2 Yrs Bear 100% 1.7 Yrs 27% 34% 37% 32% % % % Bull 9.1 Yrs 270% Bull markets are born on pessimism, grown on skepticism, mature on optimism, and die on euphoria. Sir John Templeton 17 Source: Daily S&P 500 returns, Bloomberg; as of 9/20/17

19 NAVIGATING UNCHARTERED TERRITORY WHAT ARE OUR OPTIONS TO ADD YIELD?

20 OPTION 1: EXTEND DURATION

21 OPTIONS FOR RISK POOL MANAGERS TO INCREASE YIELD: INCREASE DURATION HISTORICAL 10 YEAR TREASURY YIELD 16% 14% 12% 10% 8% 6% 4% 2% 0% Yield year Treasury yields are still near the lowest levels since 1950 More room for rates to move higher than lower 20 Source: U.S. Treasury, Irrational Exuberance by Robert Shiller as of 8/31/17

22 OPTIONS FOR RISK POOL MANAGERS TO INCREASE YIELD: INCREASE DURATION TREASURY YIELD CURVES % 5% Yield 4% 3% 2% TODAY Yield curve is at its flattest since 2007, when the level of rates was much higher Limited yield to be gained by moving further out the curve 1% 0% 3 Mos. 6 Mos. 1 Yr 2 Yrs 3 Yrs 5 Yrs 7 Yrs 10 Yrs 30 Yrs 21 Source: Bloomberg, U.S. Treasury; as of 6/30/17

23 OPTIONS FOR RISK POOL MANAGERS TO INCREASE YIELD: INCREASE DURATION YIELD ADVANTAGE VS. DURATION RISK Barclays Agg vs. Barclays Int Gov t/credit 1.2% 2.5yrs 1.0% 2.0yrs Yield 0.8% 0.6% 0.4% 1.5yrs 1.0yrs 0.5yrs 0.2% 0.0yrs 0.0% 0.5yrs Duration Agg Yield Advantage Agg Duration Difference 22 Barclays Aggregate duration is now 2 years longer than the Barclays Intermediate Government/ Credit Yield premium has shrunk to 50 bps Least attractive time to extend duration in the last 10 years Source: Barclays Live as of 8/31/17

24 OPTION 2: INCREASE RISK IN CORPORATES

25 OPTIONS FOR RISK POOL MANAGERS TO INCREASE YIELD: INCREASE CORPORATE CREDIT RISK CUMULATIVE EBIDTA GROWTH % Increase 60% 50% 40% 30% 20% 10% 0% 10% 20% EBITDA growth EBITDA (ex Energy) growth Strong cumulative EBIDTA growth since the crisis, especially when excluding the struggling energy sector 24 Source: Moody s; as of 12/31/16

26 OPTIONS FOR RISK POOL MANAGERS TO INCREASE YIELD: INCREASE CORPORATE CREDIT RISK INVESTMENT GRADE CORPORATE LEVERAGE 3.0x 2.5x 2.0x 1.5x 1.0x 0.5x 0.0x Gross and Net Leverage Debt/EBITDA Net Debt/EBITDA Debt increased 89%, causing gross leverage to rise from 1.5x to 2.5x Corporate cash increased 145%, limiting the rise in net debt leverage from 1.0x to 1.4x 25 Source: Moody s; as of 12/31/16

27 OPTIONS FOR RISK POOL MANAGERS TO INCREASE YIELD: INCREASE CORPORATE CREDIT RISK CORPORATE CASH USES $1,200bn 1200 $1,000bn 1000 $800bn $600bn $400bn $200bn $ Net Share Buybacks/Dividends Discretionary Cashflow Acquisitions Corporate actions have become an increasing risk to bondholders Increases in M&A and shareholder rewards have outstripped discretionary cashflow generation 26 Source: Moody s; as of 12/31/16

28 OPTIONS FOR RISK POOL MANAGERS TO INCREASE YIELD: INCREASE CORPORATE CREDIT RISK INVESTMENT GRADE CORPORATE BOND SPREADS (2000 TODAY) OAS Overall Corp Median Overall Corp Global demand for fixed income has tightened all spread sectors Corporate spreads are near post crisis tights and well through longer term medians 27 Source: Barclays Live; as of 7/31/17

29 OPTIONS FOR RISK POOL MANAGERS TO INCREASE YIELD: INCREASE CORPORATE CREDIT RISK BBB/A CORPORATE BOND SPREADS 300 BB/BBB CORPORATE BOND SPREADS Bps Bps BBB/A Spread Median BBB/A Spread BB/BBB Spread Median BB/BBB Spread Spreads for riskier Corporates have compressed with higher quality issuers Minimal compensation for taking on additional credit risk 28 Source: Barclays Live; as of 7/31/17

30 CORPORATE MARKET SUMMARY 29 CORPORATE MARKET SUMMARY Positive fundamentals Strong earnings growth Potential for tax reform Reasons for caution Increased leverage Greater corporate action risk Unattractive valuations Spreads near post crisis tights Through longer term medians Strategy Maintain exposure but position defensively Higher quality issuers Shorter duration bonds Extreme diversification

31 OPTION 3: INCREASE ALLOCATION TO MBS

32 OPTIONS FOR RISK POOL MANAGERS TO INCREASE YIELD: INCREASE MBS RISK SINGLE A CORPORATE SPREADS VS. MBS Bps Single A Corp attractive MBS attractive A Corp vs. CC z spread Avg A Corp less CC z Single A corporates only spread 20bps more than mortgages Smallest pick up in 7 years 31 Source: Citi, Barclays Point; as of 8/31/17

33 OPTIONS FOR RISK POOL MANAGERS TO INCREASE YIELD: INCREASE MBS RISK NET MBS SUPPLY SET TO INCREASE AS FED UNWINDS Annual MBS Supply for Private Investors $800bn $600bn $400bn $200bn $00 $200bn 200 $400bn 400 $600bn 600 Fed Buys $1tn MBS Fed Buys $900bn MBS $234bn $168bn Forecast Expected Fed Run off Fed owns $1.7tn of MBS securities, which represents 29% of the MBS market After nine years of modest net issuance, supply of MBS set to increase substantially Through 2021, Fed s MBS portfolio will shrink by $700bn (40%) and only represent 14% of the market 32 Source: Citigroup Research, Federal Reserve, Galliard estimates

34 OPTIONS FOR RISK POOL MANAGERS TO INCREASE YIELD: INCREASE MBS RISK MBS STRATEGY Attractive yields relative to other spread sectors Risks Fed Balance Sheet unwind Greater interest rate volatility Recommendation Negative convexity Duration extension if rates rise Neutral MBS exposure today Buy on any cheapening Protect downside by paying up for better convexity 33

35 PASSIVE VS. ACTIVE DEBATE CONTINUES WHO HAS HISTORICALLY WON FROM A PERFORMANCE STANDPOINT?

36 evestment LARGE CAP CORE UNIVERSE RETURNS 30% 25% 20% 15% 10% 5 th Percentile 25 th Percentile 75 th Percentile 95 th Percentile S&P 500 Index 5% 5 0% 0 1 Year 3 Years 5 Years 7 Years 10 Years Source: evestment; as of 6/30/17 Large Cap Core universe is well followed and highly efficient Active Large Cap equity managers have had a difficult time outperforming the S&P 500 benchmark consistently 35

37 evestment CORE FIXED INCOME UNIVERSE RETURNS 7% 7 6% 6 5% 5 4% 4 3% 3 2% 2 1% 1 0% 0 1% 2% 1 Year 3 Years 5 Years 7 Years 10 Years 5 th Percentile 25 th Percentile 75 th Percentile 95 th Percentile Bloomberg Barclays U.S. Aggregate Bond Index Source: evestment; as of 6/30/17 Core fixed income universe does not represent the full investment opportunity set Active core fixed income managers have had success producing excess returns versus the Barclays U.S. Aggregate Bond Index over time 36

38 ACTIVE VS. PASSIVE FIXED INCOME INVESTING Two primary drawbacks when comparing passive fixed income index to an efficient fixed income portfolio: 1. Restrictive rules for inclusion in fixed income indices High minimum issuance size excludes: Many government guaranteed programs Certain other credit sectors (Taxable Municipals, Non Corporate) Structural requirements exclude 144a, floaters, certain Agency MBS securities Bloomberg Barclays U.S. Aggregate Bond Index only captures $20tn of the total $40tn in outstanding U.S. fixed income securities 37

39 CONSTRUCTING THE EFFICIENT FIXED INCOME PORTFOLIO 2. Sub optimal sector allocations of indices LONG RUN EXCESS RETURNS VS. TREASURIES ( ) BENCHMARK COMPOSITION Bloomberg Barclays U.S. Aggregate Bond Index Galliard Core Portfolio Government Related 0.59% MBS 0.37% Treasury/ Agency/ Cash 44% 12% 13% 20% Treasury/Agency/Cash Other Government MBS ABS 0.56% Corporates 0.76% MBS 28% 15% ABS/CMBS 10% Tax Muni/Non Corp ABS/CMBS 2% Corporate 25% 30% Corporate 38 Source: Barclays Point; as of 12/31/16

40 RISK POOLS INVESTMENT CONSIDERATIONS

41 CLOSING We are not expecting a return back to historical 3% + growth; however, we do expect growth and inflation to move above recent low levels Modestly stronger economic backdrop has led to strong positive returns for investors in equity and fixed income markets, but we believe the cycle is maturing Chasing yield by extending duration and moving down the quality spectrum does not come without tradeoffs, and we are in unchartered territory as the Fed beings to unwind their balance sheet Prudent diversification and utilizing the full fixed income opportunity set is important to meet Risk Pool investment objectives 40