2013 Annual Investment Forum: Fixed Income Overview

February 1st, 2013 | By Nick Sargen

On January 17th, Fort Washington held its annual Investment Forum at the beautiful Hilton Netherland Plaza in downtown Cincinnati, Ohio. Managing Director and Senior Portfolio Manager Tim Policinski moderated a lively discussion among senior members of our Fixed Income team. In addition to Tim, members of the panel included Zulfi Ali, Vice President and Senior Portfolio Manager; Dan Carter, Assistant Vice President and Portfolio Manager; and Scott Weston, Vice President and Senior Portfolio Manager. Below are highlights of the discussion.

Q: What is our outlook on rates for 2013?

A. Dan Carter: Based on our cautiously optimistic outlook on the economy, there will be modest upward pressure on interest rates later in 2013. The key question will be whether or not the US economy will be growing fast enough to create enough jobs to reduce the unemployment rate towards the 6.5% target set by the Fed. Our outlook assumes that the unemployment rate will decline in 2013 and the market will begin to anticipate the end of Treasury and MBS purchases by the Fed and put upward pressure on long-term rates.

Q: Interest rate risk is more of a concern at this point than credit risk. Given that Treasuries are the "risk-free" benchmark for the bond market, do you feel floating rate debt or inflation protected securities are going to be more of a focus in the Treasury market?

A. Dan Carter: There will be changes to the Treasury market in light of the current low rate environment, but there will be a balance between the goals of the Treasury and investors, which are slightly different. The Treasury is actively extending the maturity profile of the debt to lock in low long-term interest rates. In a rising rate environment, investors will be looking for alternatives to reduce interest rate risk in their portfolios. One such option exists in the market today and another is being developed. The TIPS program offers inflation protection for Treasury investors, and is a well developed, liquid market. The Treasury is also developing a floating rate note program, which will begin within a year. The program should eventually grow to be a meaningful alternative for investors.

Q: The Barclays Aggregate Index is over 70% Government-related securities. Is this still an appropriate benchmark for fixed income investors?

A. Dan Carter: The Barclays Aggregate remains the standard as a benchmark that is representative of the US bond market. We do not expect this to change, as there is not a better alternative. It does not, however, represent an attractive portfolio structure in the current environment. We advise clients to adopt an active portfolio management strategy for fixed income. Passive bond market index products and investment policy statements that are closely tied to the benchmark are likely to produce inferior returns over the next 3-5 years.

Q: Are the changes to the US Government markets driving investors to other sovereign bond markets, particularly emerging markets?

A. Zulfi Ali: Emerging markets fixed income has become a mainstream asset class, attracting record inflows of $90 Billion in 2012. Low interest rates in the U.S. are pushing investors to emerging markets, but improved fundamentals have also been a big part of the reason. In 1998 the emerging market debt universe had an average rating of single B. Currently, more than 60% of the emerging market bond benchmark is investment grade rated.

Q: How has the sovereign debt crisis in Europe affected the emerging markets sector?

A. Zulfi Ali: The debt crisis in Europe has not had a direct impact on the emerging markets since none of the European peripheral countries are included in the emerging markets bond benchmarks. In general, the debt fundamentals between developed and emerging markets have flipped with emerging markets countries reducing their debt/GDP figures over the last 10 years while government debt/GDP has been trending higher in the developed countries. Therefore, the flight to quality trade that used to happen from emerging markets to the developed markets has seen a reversal with emerging market bonds trading at lower yields than the bonds of many developed countries.

Q: Through the Government Sponsored Enterprises (GSEs – Fannie Mae and Freddie Mac), the U.S. Government has traditionally played a very important role in the mortgage market. With the GSEs in conservatorship and the role of the Government in the mortgage market in flux, is the U.S. mortgage market going to change significantly (i.e. move more toward floating rate mortgages or shorter maturities)?

A. Scott Weston: In short, we believe the 30-year mortgage will continue to be the primary source of mortgage financing in the U.S., but there will be some changes as a result of the financial crisis. The new roadmap for the mortgage market is starting to emerge. The Consumer Financial Protection Bureau (CFPB) announced a qualified mortgage (QM) definition in early January which defines the standard for post-GSE mortgage origination. The details on securitization and government support are likely to emerge later this year. Lenders should begin to ramp up mortgage lending because the QM standards help define long-term risks associated with buy-backs and will help push mortgage rates lower.

Q: Where are the opportunities for investors in the MBS market and is there still upside in non-Agency MBS?

A. Scott Weston: The Agency MBS market is unattractive to us due to the low level of yields and prepayment uncertainty. In our portfolios, we have moved away from these markets over the past two years (into non-index securities- reverse mortgages, agency Commercial MBS, Asset Backed-Securities and Collateralized Loan Obligations). Non-agency MBS fundamentals are positive and the market has been strong in the post-crisis period. In general, investment grade rated non-Agency MBS returned 10+% in 2012, and below-investment grade returned 20+%. In 2013, we anticipate investment grade returns to be in the 2% to 5% range and non-investment grade returns to be in the 4% to 7% range.