Michael Santoli

Fed's in retreat, but shortage of safe bonds persists

Michael Santoli

Even after the world’s most voracious consumer of bonds pushes away from the table, there still probably won’t be enough safe, nourishing government and mortgage-backed debt to satisfy investors’ appetite for it.

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Fed Chairwoman Janet Yellen.

 This reality should dampen or forestall any rise in interest rates, while also squeezing some investors into somewhat riskier investments than they would prefer -- or, in a worst-case scenario, riskier than they are equipped to handle should financial markets become unsettled.

The Federal Reserve began scaling back its purchases of Treasury and federal-agency mortgage securities in December, reducing its monthly buying to $75 billion from the $85 billion pace that had been in place since September 2012. That was cut further, to $65 billion, last month, and, barring severe erosion in economic growth indicators, the Fed is expected to continue this “tapering” process until bond-buying sunsets by the end of the year.

As a result, the Fed this year will absorb around $435 billion in Treasury and mortgage debt, down from a bit more than $1 trillion in 2013, according to estimates by credit strategists at RBS. All else being equal, the removal of the Fed’s bid at any price would seem to orphan government-linked debt and lift interest rates. Yet, with the U.S. budget deficit shrinking faster than forecast, corporate-bond issuance ebbing from record levels and steady demand for safe paper, it’s not an exaggeration to characterize high-grade fixed income as a scarce asset class.

Supply shortage

Edward Marrinan, co-head of credit strategy at RBS, says: “We believe there has been — and continues to be — a shortage of high quality fixed-income supply on a net basis to meet the rising global demand for such exposure.”

In his 2014 outlook, Marrinan projects that gross issuance of investment-grade securities this year will dip to $1.42 trillion from $1.54 trillion last year. With the Fed on track to take in about $435 billion of that, it leaves $988 billion of likely net supply of new fixed-income paper. “While $988 billion of net supply may sound like a lot,” Marinnan says, “it does not go very far to sating global demand.”

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Chart from FactSet.

Rapid improvement in the federal deficit, thanks to a stronger economy, higher tax collections and domestic-spending restraints, could reduce that net-issuance number further.

Michael Darda, economist and market strategist at MKM Partners, notes that January Treasury data show the deficit shrank to about 3% of gross domestic product, from a high of 10% four years ago. “The deficit has been falling by 1.5% of GDP per annum since late 2010; if current trends persist, the fiscal deficit will effectively fall to zero in 2015 and a surplus of just over 1% of GDP will arise by 2016,” he adds.

J.P. Morgan has estimated that years of central-bank asset purchases left them holding a total of $24 trillion in debt, more than half the $44 trillion government, agency and corporate bonds captured by the comprehensive Barclays Multiverse Global Bond Index. It’s a huge world with lots of savings in need of a home, so $20 trillion in public hands is arguably not enough. 

Meantime, for all the chatter over the past year predicting a “great rotation” of investors from bonds and bond mutual funds into stocks, now that the market is eyeing the eventual end of zero interest rates, demand for high-grade bonds remains quite strong across the globe. 

Corporate pension funds and insurance companies crave long-term, safe instruments that allow them to securely match assets with their eventual liabilities to retirees and beneficiaries. As Jeff Gundlach, the widely followed fund manager and chief investment officer at DoubleLine Capital said Wednesday in a CNBC interview, “There is a huge bid for bonds at yields somewhat higher than they are now.” 

The strong recovery in developed-world stock markets has enabled corporate pension funds to become roughly fully funded. When this happens, these funds are eager to lock in these funding levels with safer investments that offer a bit of income.

Interesting options

Is it pure coincidence that the lift in 2013 in Treasury yields was halted at almost exactly 3% on the 10-year note and 4% on the 30-year bond – round number barriers that seem to represent value for long-term, slow-money buyers?

Any investor or institution that rebalances to a set asset mix, in fact, would be shifting money from stocks into bonds following the massive outperformance of equities last year. According to consulting firm Towers Watson, U.S. pension funds have 57% of assets in equities, the highest proportion of any country. Globally, the asset mix was 52% stocks, 29% bonds, 18% “other” and 1% cash. The markets have largely done the “rotating” for investors.

The upshot from all this is that any rise in interest rates is likely to be more restrained than many expect or fear, with plenty of intervening declines such as the one that surprised the majority of traders and dragged the 10-year Treasury yield below 2.60% from 3.02% during January.

Of course, no matter how much debt central banks hold and how much the deficit shrinks, buyers still need to show up at every Treasury auction and take down the fresh paper, so rates could certainly climb a fair bit if economic acceleration or inflationary winds becomes more evident.

Peter Boockvar, veteran bond-market watcher at the Lindsey Group, says, “Foreigners were buyers of $400 billion-plus of U.S. Treasuries in both 2011 and 2012 but have bought just a net $26 billion worth in the 11 months of 2013 thru Nov. Will others fill the gap to get this good collateral?”

Many investors have been pushed or migrated willingly to the debt of ultra-high-quality companies such as Coca-Cola Co. (KO) or Apple Inc. (AAPL) that operate almost as corporate nation-states and often can borrow at rates rivaling the most sober governments.

The quest has also sent investors piling into the once-toxic debt of peripheral European governments, with Italy’s 10-year yield collapsing to an eight-year low below 3.8%, and it just sold three-year debt at a record low rate.

This is all working fine now in the relative calm of developed-world capital markets. But whenever safety gets scarce and turns expensive, risk inevitably becomes mispriced as well.

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