fixed income market trends and perspective · return std dev sharpe ratio msci em (emerging...
TRANSCRIPT
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Fixed Income Market Trends and Perspective
Blocking and Tackling
Taxes Matter – Municipal Bonds have been a sound investment
Balanced Portfolios – Fixed income serves a role in a diversified portfolio
Global Growth Model
Growth Matters
Emerging Market Debt example
Market Environment
Since late 2002, risk has been rewarded
Valuations appear rich
The challenge of mean reversion evaluation
Structural Market Change
WIN – Whip Inflation Now – Did we win ?
How about the rest of the world ?
Globalization and convergence
Key Players and Impact
Derivative Instruments
Conclusion
Heraclitus and his takeaway
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Blocking and Tackling – fundamentals review
• In an environment where many market prognosticators have forecast a low
return environment, after tax investment considerations become important
• After adjusting for taxes, municipal bonds have been a sound investment outright
Tax Adjusted Total Returns vs. Volatility
10 Years ending 9/30/06
Credit
US TreasuriesHigh Yield
Municipals
Municipal HY
Agg
S&P 500 (15.45%)
5%
6%
7%
8%
9%
10%
11%
12%
13%
0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09 0.1
Annualized Standard Deviation
Annualiz
ed R
etu
rn
Credit is represented by the Lehman Brothers (LB) U.S. Credit Index, U.S. Treasuriesare represented by the LB Treasury Index, High Yield is represented by
the LB High Yield Index, Municipal High Yield is represented by the LB LB Tax Free High Yield Index. Municipal returns have been adjusted based on a 35%
income tax bracket assumption. Past performance cannot guarantee future results.
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100% Stocks
50%/50% Stocks/Bonds
100% Taxable Bonds
Stocks = S&P 500 Stock Index, Taxable Bonds = Lehman U.S. Aggregate Bond Index
Source: Lehman Brothers, Bloomberg
September 30, 1996-September 30, 2006
50/50 Stock/Bond returned 91% of the all-stock return with 50% of risk; 75/25 Stock/Bond returned almost 97% vs. all-stock with 75% of the risk.
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6
8
10
0 2 4 6 8 10 12 14 16
Risk (Standard Deviation, %)
Retu
rn (
%)
Blocking & Tackling – fundamentals review
Fixed Income plays a key role in diversified portfolios
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Blocking & Tackling – fundamentals review
Commodities
U.S. Rates
China Exports
U.S.
Current Account
Japan,
China etc.
•With its voracious appetite for commodities, China (akin to late 19th
century America) is a global growth engine.
•With its 7% / GDP current account deficit largely funded with foreign
fund flows, the U.S. is a global growth engine.
•Europe and India also play key roles
The Global Growth Model
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Blocking & Tackling – fundamentals review
GDP Growth vs. High Yield SpreadsMarch 30, 1990 - June 30, 2006
-4
-2
0
2
4
6
8
03/30/9
0
03/30/9
1
03/30/9
2
03/30/9
3
03/30/9
4
03/30/9
5
03/30/9
6
03/30/9
7
03/30/9
8
03/30/9
9
03/30/0
0
03/30/0
1
03/30/0
2
03/30/0
3
03/30/0
4
03/30/0
5
03/30/0
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Real
GD
P %
ch
an
ge
300
400
500
600
700
800
900
1000
1100
Sp
read
(b
asis
po
ints
)
Annualized Real GDP Growth Credit Suisse High Yield Index Spread
Source: Bureau of Economic Analysis, Credit Suisse
Growth Matters
6
Blocking & Tackling – fundamentals review
EMB spreads and oil prices
0
200
400
600
800
1000
1200
1400
1600
Dec
-93
Dec
-94
Dec
-95
Dec
-96
Dec
-97
Dec
-98
Dec
-99
Dec
-00
Dec
-01
Dec
-02
Dec
-03
Dec
-04
Dec
-05
Dec
-06
EM
B s
pre
ads
0
10
20
30
40
50
60
70
80
Oil
pri
ces
EMB spreads (L) Oil prices (R)
Source J.P. Morgan
J.P. Morgan Emerging Market Bond Index (EMB)
A strong commodity run has been a catalyst for emerging
countries and contributed toward “convergence”
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Market Environment
Risk-Return Table
January 2003 - December 2006: Annualized Stats
Return Std Dev Sharpe Ratio
MSCI EM (EMERGING MARKETS) 36.89 16.8 2.03
JPM EMB Global Index (jpmrg) 14.33 7.01 1.67
Credit Suisse High Yield Index 13.15 4.38 2.40
Credit Suisse High Yield CCC/Split CCC 19.97 8.26 2.09
Russell 2000 Value 23.26 13.35 1.54
NASDAQ Composite 16.74 13.71 1.03
S&P 500 14.74 8.28 1.46
Lehman US Aggregate Bond Index 3.80 3.75 0.34
Since 2002 risk has generally been handsomely rewarded
Source: Zephyr Style Advisor
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Market Environment
EMD Yield Spread Over U.S. Treasuries
0
500
1000
1500
2000
2500
12/3
1/9
0
12/2
8/9
2
12/2
8/9
4
12/2
6/9
6
12/3
0/9
8
12/2
9/0
0
01/0
3/0
3
01/0
6/0
5
50
150
250
350
450
550
650
1/2/04 3/22/04 6/10/04 8/29/04 11/17/04 2/5/05 4/26/05 7/15/05 10/3/05 12/22/05 3/12/06 5/31/06 8/19/06 11/7/06
1
JPM Global HY Index & LB Aggregate – Spreads
January 11, 2004 through January 11, 2007
Source: Bloomberg and Lehman Point
JP Morgan Emerging Market Debt Spreads over US
Treasuries – December 1990 through January 2007
Source: JP Morgan
Valuations appear rich
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Market Environment
% Investment grade
0%
10%
20%
30%
40%
50%
Dec-93 Dec-94 Dec-95 Dec-96 Dec-97 Dec-98 Dec-99 Dec-00 Dec-01 Dec-02 Dec-03 Dec-04 Dec-05 Dec-06
% I
nv
es
tme
nt
Gra
de
% Investment grade
Historic spread analysis does not capture qualitative or structural change
In the case of EMD, a favorable commodity cycle in conjunction with:
Fiscal discipline Change in ownership base – pension funds
Abandonment of fixed exchange rate regimes Convergence
Global search for yield
The challenge of mean reversion analysis
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Structural Market Change – WIN
• Whip Inflation Now – it looks like the inflation war has been won in the US
Annual Growth Rate of CPI
0%
5%
10%
15%
1975 1985 1995 2005
Source: International Monetary Fund
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Structural Market Change – What about the rest of
the world ?
World Inflation Rates
0
5
10
15
20
25
30
35
40
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
Source: International Monetary Fund
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Structural Market Change – Globalization & Convergence
“ In a nutshell, I believe that the factors of globalization, deregulation, and financial
innovation, arising partly in response to episodes of high inflation, have effectively
eroded the central bank monopoly on the provision of monetary services and have
enhanced global competition among currencies. These changes have, in turn, altered the
incentives for central banks to behave badly and for finance ministries to use central
banks as "piggy banks" to finance their fiscal policies. The resulting constraint on
monetary policy, combined with increased public understanding of the costs of inflation,
have led to institutional changes in central bank governance that bolster their credibility
for maintaining price stability in the future. Improved central bank performance and
credibility, thus, are the consequences of this combination of factors.”
Source: Remarks by Federal Reserve Governor Randall S. Kroszner
At the Cato Institute Monetary Policy Conference, Washington, D.C.
November 16, 2006 “The Conquest of Worldwide Inflation
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Structural Market Change – Globalization & Convergence
A global trading club (with rules):
• European Union – Economic guidelines for entry
• Global standards for trade - International Organization
Standards (ISO) - together with IEC (International Electrotechnical
Commission) and ITU (International Telecommunication Union) - has built a
strategic partnership with the WTO (World Trade Organization) with the
common goal of promoting a free and fair global trading system
Source: http://www.iso.org
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Structural Market Change – Key Players and Impact
• Hedge Funds – Lehman Brothers research estimates there are currently 9,000 hedge funds
managing approximately $1.7 trillion in assets
• Private Equity – Strong flows into private equity in conjunction with the willingness of private
equity players’ to “partner” has increased the pace and scale of LBO activity.
In the 18 months prior to August 2006, nine of the ten largest buyouts
in history have been announced or completed. (source T. Rowe Price)
• Pension Funds – The Pension Protection Act passed in July 2006 directly impacting
approximately $1.6 trillion in DB pension assets. Although different than the US, it is generally
believed that the inversion of the yield curve in the U.K. has largely been attributable to a version
of pension reform
• Tender Option Bond (TOB) Programs – Structurally designed to provide institutional clients with
yield by essentially borrowing short, investing long and adding a degree of leverage to amplify the
yield. Is generally believed to be a strong contributor to flatness of today’s municipal curve
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Structural Market Change – Derivatives
Not a dirty word
When used in moderation, derivatives can increase the efficiency of the
portfolio management process and aid in risk management
Instruments that fall under this label include:
• Futures – can be used to manage interest rate risk. Favorable on certain bonds that have a
degree of illiquidity, but concerned with near term valuation, a short interest rate futures trade can provide a hedge
• Options – In international portfolios, can be long on a currency option to hedge interest rate risk at the country level
• Credit Default Swaps – A tool for managing risk at security specific and market levels. Other practical applications as well
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Conclusion – What can we learn from Heraclitus
In an age of abundant data, historical information provides an invaluable frame of
reference for making investment decisions today. Qualifying an historical perspective
with an understanding of how the world today is unique relative to the past is an even
more potent formula for success. As the French found out in the late 1930’s, while a
formidable structure, the Maginot Line was not built for the type of warfare that unfolded
during the Second World War.
Heraclitus - A Greek philosopher of the late 6th century
BC, who said, “You can never step into the same river;
for new waters are always flowing on to you."
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Final appendix
• Past performance cannot guarantee future results.
• All charts are for illustrative purposes only and not meant to represent an investment in any particular security. It is not possible to invest directly in an index.
• Diversification cannot assure a profit or protect against loss in a declining market.
• Risks:
• Interest Rate risk: This is the decline in bond prices that usually accompanies a rise in interest rates. Longer-maturity bonds typically decline more than those with shorter maturities.
• Credit risk: This is the chance that any fund holding could have its credit rating downgraded, or that a bond issuer will default (fail to make timely payments of interest or principal), potentially reducing the fund's income level and share price.
• High-Yield Investing A fund investing in high-yield corporate bonds, often called "junk bonds," could have greater price declines than funds that invest primarily in high-quality bonds.
• Emerging market Risk: Investments in emerging markets are subject to abrupt and severe price declines, and should be regarded as speculative. The economic and political structures of developing nations, in most cases, do not compare favorably with the U.S. or other developed countries in terms of wealth and stability, and their financial markets often lack liquidity.
• Derivatives: Investing in derivative instruments may involve substantial risk. The risks of investing in derivatives should be carefully weighed as it is possible to lose more than the amount invested.