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The federal budget deficit: “Neither a borrower nor a lender be”

Marc Wiersum, MBA

Fixed income ETF must-know: Has the bear market in bonds begun? (Part 3 of 5)

(Continued from Part 2)

The federal budget deficit

The below graph provides additional support for the economic recovery thesis. Since Obama raised capital gains taxes from 15% to 20% (for the top tax bracket) in the face of a government-induced economic rally, capital gains tax–related revenues have helped pay down the crisis-induced federal debt.

This article considers the improvement in the federal budget deficit and the implications for fixed income investors. For a detailed analysis of the U.S. macroeconomic environment supporting this series, please see Must-know 2014 US macro outlook: The crack in the debt ceiling.

Capital gains, deficit wanes

In 2007, at an equity market peak, long-term capital gains taxes reached 6.14% of GDP, or approximately $118 billion. In contrast, at the bottom of 2009, capital gains taxes fell to 1.62% of GDP. 2013 saw growth in capital gains-related tax receipts as tax payers sought to make final payments on 2012 tax receipts under the 15% rate regime. Accordingly, 2013 capital gains tax revenues reached $483 billion, or roughly 3.00% of GDP. As the stock market reaches new highs, it’s possible that the growth in capital gains-related tax revenues alone could be almost enough to put an end to the current federal budget deficit, which is now less than 4.00%.

More pressure on bonds

As the federal budget deficit shrinks and the Federal Reserve Bank buys fewer Treasury bonds as part of its “QE3” bond buying program, it would appear that the post-crisis bond buying spree could be slowing down. As we discussed earlier, the fairly rapid rise of the ten-year bond from 1.5% in July 2012 to 3.0% in December 2013 reflected investors’ concerns that the fundamental supply and demand balance for long-dated bonds was changing and will likely continue to reflect less demand in the future.

Accordingly, as economic growth returns to historical averages, budget deficits shrink on tax revenue gains, and the Federal Reserve Bank buys fewer bonds, long-dated bonds and fixed income-related bond EFTs with longer durations may experience further price declines.

To see why the declining yields in the ten-year bond may be reversing, please see the next article in this series.

For additional analysis related to other key fixed income ETF tickers, please see the related series Fixed income ETFs: Short-duration alternatives for bonds.

Outlook: High credit quality and longer-duration (TLT & BND) versus lower credit quality and mid-duration (HYG & JNK)

For fixed income investors concerned with rising interest rates and falling bond prices, long-dated (long duration) ETFs such as the iShares 20+Year Treasury Bond ETF (TLT) may continue to see price declines if interest rates continue to rise. Note that the TLT ETF has a duration of approximately 16.35 years—roughly twice that of the current ten-year Treasury bond at 8.68 years. In contrast to the long-dated TLT, the iShares iBoxx High Yield Corporate Bond ETF, HYG, has a much shorter duration of only 3.98 years, as well as exposure to improving commercial credit markets, and may continue to outperform the long duration TLT ETF in a rising rate environment.

However, investors should note that the High Yield portfolio of HYG holds roughly 90% of its portfolio in bonds rated BBB3 through B3, with roughly 10% of its portfolio in CCC-rated credit (substantial risks). HYG top holding includes Sprint Corp (S) at 0.56% of the portfolio. The Vanguard Total Bond Market ETF (BND) maintains a duration of 5.5 years, though it holds 65.4% of its portfolio in government bonds and 21% of his holdings in AAA–A rated bonds. Compared to HYG and JNK, the BND ETF is slightly longer in duration (BND 5.5 years versus HYG 3.98 and JNK 4.20). But it’s very much concentrated in government and high-quality bonds, and will therefore be less impacted by changes in the overall commercial credit markets.

Lastly, for investors looking to maintain yield while gaining exposure to the commercial credit market, an alternative to the iShares HYG, the Barclays High Yield Bond Fund ETF (JNK), offers a similar duration of 4.20 years versus HYG’s 3.98 years, holding 84.17% of its portfolio in corporate industrial, 7.65% in corporate utility, and 7.5% in corporate finance-oriented bonds. Like HYG, even JNK is a big fan of Sprint (S), with its top holding of First Data Corporation (0.72%) followed by Sprint Corp. (0.62%), Sprint Communications (0.59%), and HCA Inc. (0.53%).

Continue to Part 4

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