Schwab Bond Insights: Treasuries, Preferreds, FAQs, Muni Hot Spots
- Treasury bonds have defied expectations year-to-date, forcing us to lower our projections and guidance for the rest of the year.
- Yields on preferred securities have dropped this year, giving them double-digit price gains.
- Overall credit conditions in the municipal bond market are pointing up, but there are a few pockets of weakness.
Treasury bonds have defied expectations year-to-date, forcing us to lower our projections and guidance for the rest of the year.
While the consensus view was that yields would rise in 2014, so far Treasury yields have fallen. The 10-year Treasury bond hit its year-to-date low of 2.44% on May 28, compared to 2013’s closing yield of 3.03%. The drop in yields has pushed prices higher, leading to strong performance for most domestic fixed income asset classes.
Despite the decline so far, we believe the trend for Treasury yields will be higher as the year goes on. However, we are lowering our expectations. Rather than rising to the 3.5% area that we originally projected, we see yields climbing to around 3%. But it may be a bumpy ride to get there.
One reason: We think investors are waiting to see data confirming that the economy is strong enough to withstand less support from the Federal Reserve. While the consensus forecast of economists is that second quarter growth will pick up, we can't ignore the performance of the first quarter, even though much of it can be attributed to weather-related factors. The U.S. economy shrank 1.0% in the first quarter, notching an even bigger decline than expected, according to the government's May revision of the GDP estimate.
Even with the first quarter weakness, the Fed still appears to be on pace to end its bond purchases sometime in the fourth quarter of this year, and then ultimately raise rates sometime in the second half of next year.
With 10-year Treasury and 30-year Treasury bond yields down 59 and 67 basis points, respectively, to start the year, we don’t think it’s the best time to be adding duration to your bond portfolio. We’d wait for 10-year Treasuries to get back to the 3% range.
Are Preferred Securities a Smart Investment Now?
For investors considering investing in preferred securities to boost portfolio income, we suggest waiting for yields to move a bit higher.
Yields on preferred securities have dropped this year, following the path of long-term Treasury yields. Falling yields have driven strong price appreciation, since prices and yields move in opposite directions. But that also means investors are locking in lower yields today, with less potential price appreciation. And it's not just smaller price gains that investors are risking now. With long-term Treasury yields at levels not seen since October 2013, there's a greater risk of prices actually falling going forward.
Double digit returns to start the year
Preferred securities have been one of the strongest-performing domestic fixed income sectors year-to-date. The BofA Merrill Lynch Fixed Rate Preferred Securities Index posted a total return of 10.5% through May 16, triple the 3.5% registered by the Barclays U.S. Aggregate Bond Index and more than double the 5.2% for the Barclays U.S. Corporate Bond Index. Declining Treasury yields have been the key driver of performance.
Since long-term Treasury yields have fallen this year, the prices of preferred securities have risen sharply higher. This is partly because preferred securities have long maturities or even no maturity dates at all. This generally leads to a higher duration, a measure of interest rate sensitivity.
So far this year, 10- and 30-year Treasury bond yields are down 51 and 62 basis points, respectively.1 (One basis point is equal to 0.01%.) The average price of securities in the BofA Merrill Lynch Fixed Rate Preferred Securities Index rose from $94.70 at the end of 2013 to $102.50 on May 16. We believe the phrase "past performance does not guarantee future results" applies here.
How low are preferred securities' yields today?
The yields on preferred securities aren't that much lower today than where they stood before the financial crisis. The same can't be said for many other domestic fixed income asset classes.
For example, as of May 16, the 10-year U.S. Treasury bond offered a yield of roughly 2.5%. On May 15, 2007, the yield was 4.7%—more than 200 basis points higher than it is today. Yields on new-issue preferreds, however, aren't that much lower than in 2007, despite the fact that long-term Treasury yields were significantly higher then.
The table below shows some common issuers of preferred securities, comparing the characteristics of securities issued recently with securities issued back in 2007. As you can see, while the coupons offered are lower now than in 2007, the difference isn't as dramatic as in other fixed income asset classes like Treasuries or corporate bonds.
Ratings (at Issuance)
JPMorgan Chase & Co
JPMorgan Chase & Co
Source: Bloomberg. For illustrative purposes only. No mention of a particular security here should be construed as a recommendation or considered an offer to sell or a solicitation to buy any securities. You should not buy or sell any preferred security without first considering whether it is appropriate for you based on your own particular situation. AT&T Inc. and Verizon Communications currently have similar ratings and are in the same sector. Their preferred security issues illustrated above are the same structure (senior note), so given the similarities between the two companies, we believe this is an applicable comparison.
It's important to point out that the characteristics of many preferred securities have changed over the past few years. These changes may be part of the reason yields remain so close to their 2007 levels. One of the biggest changes has been the structure of the new issuance.
In the years leading up to the financial crisis, many of the new-issue preferred securities were issued as "trust preferred securities," a hybrid investment that has both bond-like and equity-like characteristics. Due to changing financial regulations, these no longer benefit the issuer. As a result, most recent preferred issuance by financial institutions has been of the "preferred stock" variety. There are some important differences when comparing trust preferred securities with preferred stock:
- Cumulative versus non-cumulative payments. Preferred stock pays dividends that can be deferred without triggering a default. If they are deferred, the payments are non-cumulative, meaning the issuer does not need to make up any past payments. Trust preferred securities often have cumulative interest payments. If the issuing firm begins to pay the interest payments again, it has to also repay any deferred payments. The dividends on some preferred stock issues, like those issued by real estate investment trusts (REITs) may be cumulative, however.
- Perpetual versus fixed maturity dates. Preferred stock generally has no maturity date, meaning it is perpetual in nature. Trust preferred securities have maturity dates of usually 30 to 60 years.
- Credit ratings. Preferred stock may have lower credit ratings than trust preferred securities, due to its more equity-like features. In general, the credit ratings for most preferred securities are lower today than before the financial crisis, especially for financial institutions. In fact, many financial institutions have been downgraded to sub-investment-grade territory, making it more difficult to build a diversified preferred securities portfolio composed of investment-grade issues. This may be part of the reason yields aren't much lower than before the financial crisis. These changes in the characteristics of preferred stocks increase their risks relative to trust preferred securities. As a result, investors have demanded higher yields.
While we are cautious on preferred securities in the near term, since we see risks of yields rising from their current levels, we don't think yields will rise significantly higher. Because preferred securities have long (or no) maturities, they are heavily influenced by long-term Treasury yields—and we've recently lowered our projections for long-term Treasury yields.
Slow income growth, milder credit growth, and a general softness in the economy could prevent long-term yields from spiking much higher, in our view. Rather than waiting for 10-year Treasury yields to rise to 3.5% or higher to begin to add duration to your fixed income portfolio, we think investors should consider adding duration when they get closer to 3%. Since the yields on preferred securities are influenced by long-term Treasury yields, it may make sense to consider preferreds when the 10-year Treasury yield hits 3% as well.
What else do I need to know?
Although preferred securities have long maturities (or no maturities at all), they can often be retired ("called") prior to maturity by the issuing company. Historically, firms often retire a preferred early if it can be refinanced at a lower rate. If yields move higher, it's less likely that low coupon preferreds would be retired early by the issuer. They would likely have to refinance at a higher rate. You should never assume a preferred will be called at its first call date—always consider it a long-term investment.
The option for the issuer to retire it early can also help lower the duration of a preferred. However, the risk/reward for preferred securities is lopsided. If yields fall, the issuer may be able to call in the preferred (at its par value, usually $25) and issue a lower coupon preferred. This limits the upside potential in a preferred's price. However, if yields rise, the issuer is less inclined to call the preferred and it will behave more like a long-term bond—meaning its price is more sensitive to that rise in yields.
What to do now?
Preferred securities generally offer the highest yields of domestic investment-grade securities, but they come with more risks—a combination of credit and interest-rate risk. While yields for most fixed income investments are higher than a year ago, the drop in yields this year has made us more cautious about preferred securities in the short-term. With the potential for long-term yields to move higher down the road, investors should be aware of how that affects the price of preferreds. We think there may be better entry points in the market, and that it makes more sense to tactically add preferred securities when the 10-year Treasury yield gets closer to 3%.
Bond FAQs: What's Our Interest Rate Outlook?
What’s your interest rate outlook for the second half of the year?
We think the trend for long-term Treasury yields will be higher, as long as the economy continues to improve. However, we have recently lowered our long-term yield expectations.
Ten-year Treasury yields have historically moved in tandem with the economic growth rate. Over the past decade, 10-year Treasury yields have come in about 0.75 percentage points lower than the nominal growth rate in the U.S. Since late 2012, the year-over-year nominal growth rate has averaged about 3.5%. We believe the economy has the potential to reach a growth rate of 4% later this year, so subtracting 0.75% from 4.0% gives us an estimate of 3% to 3.25% for the 10-year Treasury.
We also look at real yields—yields that take inflation into account. In the five years prior to the financial crisis, real 10-year Treasury yields averaged between 1.5% and 2.5%, depending on economic conditions. Today, the real 10-year Treasury yield is about half of one percent, or 0.5%. Inflation-adjusted yields should reflect the real cost of capital for investment. When real long-term rates are low it either reflects very weak economic conditions or the potential for a rise in investment. We think a rise in investment is more likely than renewed weakness in the economy.
So if the economy continues to grow even at a moderate pace of 2.5%, the real yield on long-term bonds will probably move higher. For the second half of the year, we’re estimating that 10-year Treasury yields could rebound to about 3.0%. Earlier in the year, we thought 3.5% was a potential upside target for 2014, but that’s looking less likely now.
I’m still waiting for Treasury yields to hit 5%. When will that happen?
We don’t think that will happen anytime soon. We think long-term bond yields will peak at lower levels than years past. Since long-term bond yields are heavily influenced by economic growth, we watch the potential growth of our economy. We think certain demographic trends could lower the potential growth rate—specifically the slow pace of household formation and the slowdown in the growth of the labor force.
Household formation has dropped recently, which can largely be attributed to the number of 18- to 34- year olds (“Millennials”) who are still living at home. This is likely due to the soft job market for younger people, high levels of student debt, and the lack of affordable housing, to name a few reasons. Secondly, with the aging of the baby boom generation, the growth rate in the labor force has begun to slow. Since economic growth can be thought of as the sum of the growth rate in those that are working and what they are producing, we’ll likely need to see productivity increase to offset the slowing trend in the size of the labor force.
Barring some major change in these trends, the long-term trends suggest that a reasonable target for 10-year Treasury yields is more likely to be in the 4% to 4.5% region a few years down the road, rather than at the 5% to 6% level of the early 2000s.
Since bond yields have dropped this year, how should I be positioned now?
In our view, investors should consider limiting their duration to no longer than the intermediate-term—meaning five to seven years for Treasuries and investment grade bonds, and 7 to 10 years for municipal bonds. The prices of long-term bonds are the most sensitive to changes in interest rates. Since long-term Treasury yields have fallen so much this year, we think the trend going forward will likely be higher, pushing prices lower.
The slope of the yield curve is positive, and it's actually pretty steep—meaning the yields on long-term bonds are higher than those of short term bonds. As you can see in the chart below, the highest incremental yield peaks in the three-year region. By incremental yield, we mean the additional yield you earn by moving to a bond with a maturity date one year later.
Note: Incremental yields are calculated by taking the given year's yield to maturity minus the prior year's yield to maturity. The incremental yields are based on yields of actual Treasury securities, therefore the month of maturity for each Treasury may differ.
Source: Bloomberg, as of May 19, 2014.
Although the incremental yield is at its peak around three years, we think those bonds could be affected the most when the Fed begins to raise its short-term rate from zero. In the past, long-term interest rates have tended to peak before the Fed is done raising rates. Consequently, we think it makes sense for investors to add longer-term bonds gradually as interest rates move up down the road.
What are your thoughts on using “bond alternatives” in place of bonds?
With yields so low, many investors have been adding other income-oriented investments like dividend-paying stocks, master limited partnerships (MLPs) and real estate investment trusts (REITs) to their portfolios. Since these types of investments pay income, they are often thought of as bond substitutes. We disagree. Bonds have unique characteristics that tend to make them less volatile than equity investments and provide portfolio diversification.
Bonds have a par value and a set maturity date, and they generally pay a fixed coupon rate. Income-focused equity investments don’t share those characteristics. Dividend-paying stocks, MLPs, and REITs are all are equities whose dividend payments are discretionary, so their prices are generally more volatile than bonds.
When investing in bonds, you know what you’ll receive at maturity, barring default. The same can’t be said for equities, but they do offer greater growth potential. Also, income-oriented equity investments generally behave like bonds when interest rates rise, often leading to lower prices. As a result, these can offer the volatility of stocks while sharing the interest rate sensitivity of bonds.
For something to be a bond “alternative,” it needs to behave like a bond—and these types of investments don’t do that all of the time. Bonds are meant to help diversify a portfolio, provide steady income, and help preserve capital. These income-oriented equity investments don’t check all of those boxes.
Hot Spots in the Municipal Bond Market
While we have a favorable view on the overall credit conditions of the municipal bond market, it's worth highlighting a few hot spots that have been attracting attention.
On the positive side, state revenues have grown for 16 straight quarters on a year-over-year basis.2 The housing market has been improving—a trend we believe will be a positive for municipalities going forward. Plus, several high-profile states have delivered budgetary and political reforms. Although credit conditions as a whole appear to be pointing up, with nearly 60,000 issuers in the market, it's inevitable that some pockets warrant additional scrutiny. They include:
- Michigan general obligation (GO) bonds
- Chicago bonds
- Tobacco settlement bonds
We are purposefully leaving Puerto Rico and Detroit off of this list because the problems facing these two areas have been covered extensively, including by us.
GO bonds in Michigan
On April 9, the city of Detroit reached a tentative settlement with the holders of its unlimited tax general obligation (GO) bonds. The settlement, which still needs to be approved by the bankruptcy court, was only with the city's unlimitedtax GO bondholders and not its limited tax GO bondholders. Unlimited tax GOs are often secured by a specific tax and usually carry a promise by the issuer to raise taxes to whatever amount necessary to meet the debt service. Limited-tax GO bonds, on the other hand, don't carry these same promises but are often viewed by market participants as having very strong pledges.
As the plan stands now, unlimited tax GO bond holders—consisting mostly of the bond insurers—are to receive 74 cents on the dollar, whereas limited tax GO bond holders are slated to only receive 10-13 cents on the dollar. Although this plan calls for the insurance companies to receive less than the full principal amount, investors in insured bonds are still scheduled to receive 100% of their principal and interest payments, paid from the insurance companies backing the bonds instead of Detroit.
Limited tax GOs generally contain statutory clauses designed to distinguish them from subordinated (meaning lower ranking, in the order of payments) bonds. According to Municipal Market Advisors, if the proposed plan of adjustment is accepted, limited tax GO bonds may be treated on par with other lower ranking creditors. This concerns us because if limited tax GOs are allowed to be significantly impaired, it could pave the way for troubled Michigan limited tax GO issuers to pursue a similar path in the future. Therefore, we believe additional caution is warranted when it comes to limited tax GOs in the state of Michigan.
Due to differences in state constitutions and management, we do not believe that the outcome of the Detroit case will set a clear precedent for GO bonds in other states.
The city of Chicago
It's no secret that the windy city has been facing issues of its own. On March 4, Moody's downgraded the city from A3 to Baa1, affecting $8.3 billion of GO and sales tax debt. Moody's also downgraded the city's water and sewer revenue bonds. In explaining the downgrade, the rating agency pointed to "massive and growing unfunded pension liabilities (that) threaten (the) city's long-term fiscal solvency." 3
As the chart below shows, the city of Chicago has one of the lowest funded pension ratios compared to other major cities. However, although reform will likely be an uphill battle, the city has taken steps recently to address its growing pension problem.
Source: The Pew Charitable Trusts, selected cities have the 10 lowest funded pension ratios of the 40 contained in the original report, pension funded levels are for fiscal year 2010, report is as of January 16, 2013.
While Chicago faces difficult financial issues in the near term, we believe it is far from going the way of Detroit. Detroit faced a combination of problems that are not present in Chicago, at least not currently. Detroit's economy was largely tied to a single industry—automotive—which was heavily hit during the 2008 credit crisis. Chicago, in contrast, has a larger, more diverse economy.
The income and demographics picture is also vastly different in Chicago. The windy city's 2011 household median income was nearly 175% the median income of Detroit.4 Between 2000 and 2011, Detroit also lost more than a quarter of its population, while Chicago experienced just a 6.5% decline.5 Chicago's diverse economy, higher median income, and comparatively stable population provide it with credit flexibility, making it unlikely that Chicago will soon follow in Detroit's footsteps.
Tobacco settlement bonds
Tobacco settlement bonds were created as a result of a 1998 national settlement between the major tobacco companies and states. As a result of the settlement, major tobacco companies agreed to pay states annually to resolve liabilities for health care costs related to smoking. Some states chose to borrow against this payment stream by issuing bonds. The bonds are secured by payments from the tobacco companies and these payments are based on cigarette shipments.
The good news, from a health perspective, is that cigarette consumption has been declining nationally. The bad news, from a bondholder perspective, is that fewer smokers means less money from the tobacco companies. In fact, Moody's projects that, "65%-80% of the aggregate outstanding balance of all tobacco settlement bonds (it) rate(s) will ultimately default," if shipments continue to decline based on the rating agency's projections.6
Source: Moody's Investor Services, as of May 8, 2014.
Given the decline in cigarette consumption and the introduction of smoking alternatives—e-cigarettes, for example—the future for tobacco settlement bonds is in question. Also, yields on high-yield tobacco bonds have been declining since peaking in September of last year. We believe that given the uncertainty surrounding tobacco settlement bonds and their lower yields, this part of the municipal market warrants additional caution.
Source: Barclays, as of May 20, 2014.
What to do now
The municipal bond market is a large and diverse market, and credit conditions are strengthening, in general. However, there are pockets where we believe additional caution is warranted. For most muni portfolios, we suggest higher-rated issuers of AA-rated quality or higher. While ratings agencies have recently been under fire, they have been good predictors of credit quality. For lower-rated issuers, talk with a Schwab specialist and review the latest filings, rating reports, and financial performance.
1. As of May 16, 2014
2. Nelson A. Rockefeller Institute of Government, as of April 2014.
3. Moody's Investor Services, as of March 4, 2014.
4. The Pew Charitable Trusts, as of March 1, 2013.
5. The Pew Charitable Trusts, as of March 1, 2013.
6. Moody's Investor Services, "Decline in Cigarette Shipments Will Hurt US Tobacco Settlement Bonds," as of May 8, 2014.
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