In this month's LDI market commentary:
• September’s Treasury market action
• Credit outlook for technology companies
September’s Bond Market Activity — Treasury Market Rally
Yields rose dramatically on solid economic news. Fed and ECB comments which, while not hawkish, were less dovish than anticipated, and the release of a tax reform plan, set a tone for better growth and rising rates. Equities finished at record levels. Oil prices also advanced.
Fed comments confirmed balance-sheet tapering this fall, along with one more probable rate increase this year. The curve noticeably flattened. Ten-year Treasury yields rose 22 basis points to 2.34% while 30-year Treasuries climbed a more modest 13 basis points to 2.86%. The comments confirmed a positive economic outlook leading investment-grade credit spreads to tighten 9 bps with widespread strength most visible in energy, banks and autos.
September new issuance was in line with expectations at $115 billion as Discovery, Apple and Bank of America all had $5 billion to $6 billion deals. Expectations for October are $75 billion to $85 billion. Year-to-date issuance is essentially flat compared to last year.
Sector Outlook — Technology
Bonds issued by technology companies have become one of the largest constituents of the broader investment-grade corporate universe. Away from M&A, much of the debt issuance has been used to fund share repurchases, despite generally strong cash flow characteristics and sizable cash piles on the balance sheet that often exceed total debt outstanding. Since many of the largest technology companies generate the majority of their cash flows outside the U.S., they have been issuing relatively low-cost debt to fund shareholder returns instead of paying the required taxes to repatriate offshore cash.
In addition to tectonic fundamental shifts impacting the technology sector, such as the migration of enterprise computing to the cloud, a key area of investor interest over the past 12 months has been the increasing potential for tax reform. To the extent legislation is passed that would allow the large technology companies to access their cash in a tax efficient manner, we can anticipate significant positive implications for supply and bond valuations in the sector.
Structural Issues — Market Efficiency
The behavior of Treasury yields and risky assets in today’s news-rich environment provide some interesting case studies of market efficiency. Financial markets are often assumed to be highly efficient information-processing machines, instantly incorporating new data. This expectation is close to the truth for standard economic data releases, which move markets within minutes. But it may not be true for “softer” information that requires more human judgment to process. Here are three recent examples where the initial market reaction reflected a superficial take. A deeper analysis took longer to filter into market pricing, leaving ample space for active management to add value.
First: on September 27, the markets priced in very optimistic expectations for corporate tax cuts as part of a tax reform bill passed by a bare majority via reconciliation. In fact, unlike individual tax cuts, corporate tax cuts have to be phased out years before the 10-year window to comply with the Byrd Rule because they affect tax loss carry-forwards that impact revenue in future years. It took two more days before this nuanced analysis began to be reflected in Treasury yields.
Second: on September 29, news that former Fed Governor Kevin Warsh was being considered for Fed Chair sparked a yield curve reaction based on his perceived hawkishness relative to Janet Yellen. The rates market tends to overlook the fact that recent Fed appointments have been driven more by (de)regulatory rather than monetary policy considerations, and the known information about Warsh’s former interactions with Fed staff.
Third: the risk of a North Korean incident has triggered several downward shocks to bond yields and risky asset prices recently, and has probably had some persistent effects as well. Yet the market tends to focus on observed military actions and U.S. and North Korean rhetoric. In fact, the outcomes will be more strongly influenced by China-North Korea relations and by internal dynamics within North Korea (Kim Jong Un’s need to navigate competing factions). Thus an “obvious” geopolitical risk may not be efficiently priced in the short run.
(Portfolio managers Andy Barth and David Lee, along with analyst Mital Kotecha, contributed to this report.)