Path To Normalization Remains Long, But U.S. Treasury Bonds Grow More Attractive

PASADENA, Calif., June 2, 2015 /PRNewswire/ -- Despite subpar growth and the possibility of postponed U.S. Federal Reserve rate hikes, 30-year U.S. Treasury bonds have sold off sharply recently. To Western Asset Management Chief Investment Officer Ken Leech, this largely reflects spillover from Europe, fundamental factors and position unwinds – and creates opportunity for investors.

"We continue to focus portfolio construction around the global and U.S. recovery theme," Mr. Leech wrote in his most recent Market Commentary. "Despite the recent pullbacks in growth, monetary policy remains very accommodative – so much so that markets can violently overshoot, bringing greater volatility. Investors trying to reap the rewards from the global recovery must stay attentive to risks to both the upside and the downside; that is, faster and slower growth. The former seems most likely, but the latter would clearly cause the most pain."

The full Western Asset Market Commentary can be found on Western Asset's web site.

In the previous quarter, Mr. Leech noted that the growth and economic environment was favorable for U.S. Treasury bond (UST) duration, but he had held back as valuations were too stretched.

"Now, the environment is even more favorable," he advised. "U.S. growth came in even lower than we previously thought. While we maintain our 2 to 2.5 percent growth forecast, the risk is clearly to the downside, and the threat of such an undershoot is already leading short rates lower, yet the valuations of longer securities have become meaningfully more attractive."

Regarding the global perspective, Mr. Leech wrote, "The downshift in U.S. and Chinese growth, combined with ongoing challenges to many commodity-export-driven emerging markets, increases the downside risks to global growth. The good news is that global policy has been responsive, but the rebound in growth is still elusive."

Adding duration in this mild growth, low inflation, and policy-heavy rate environment appears particularly attractive to Mr. Leech.

"The path to normalization will be long but we will remain diligent in frequently readjusting portfolios, constantly striving for the best combination of risk and reward," he explained. "Adding short maturity duration helped us late last year and early this year. Our underweight in USTs has helped over the past few months. Hopefully, our current retention of some additional UST insurance will also prove beneficial."

Mr. Leech and his team also look for opportunities globally.

"Our allocation to non-USTs has been beneficial as our bottom-up approach, characterized by careful valuation analysis and research-driven selectivity, puts us in good position to find value," he reported. "Our allocation to high-yield energy companies — a primary focus of ours this year — has been particularly advantageous. We continue to be positive on spread sectors, particularly emerging markets, where we are optimistic that the recent sharp turnaround will continue."

As he tracked markets roiled by uncertainty, particularly in Europe, the concept of negative-yield, long-dated German bunds struck Mr. Leech as a potentially unfathomable "rabbit hole."

"Since then, we have seen some extraordinary mayhem in the European bond markets," Mr. Leech wrote. "Yields on the German 10-year bund shot up from a mere 7 basis points (bps) to 83 bps in just a few days. This occurred even as the European Central Bank (ECB) was embarking on a historic asset purchase program likely to last at least through September 2016. The ECB's package at roughly €1.14 trillion aims to forestall deflationary pressures and improve growth through the mechanisms of lower interest rates and a weaker euro."

"While we agree that the ECB's program would indeed lower yields and euro exchange rates, we thought market valuations had become stretched when bund yields approached zero and the euro approached parity to the dollar — so much so that underweighting or even shorting bunds seemed to be in order. We thought valuations would win out slowly. The ECB's formidable firepower and intentions were clear."

That view was borne out, but to a stunningly quick degree and with surprising ramifications for other markets. Over the last four weeks, German bund volatility has surged, and prices of 30-year securities have fallen by as much as 30 points.

"The spillover to the U.S. market has been pronounced," Mr. Leech observed. "Longer maturity UST yields have moved up sharply, even as U.S. economic growth has sputtered. First-quarter GDP came in at a meager 0.2 percent and is likely to be downwardly revised to negative."

Normally, subpar growth and the stronger possibility of the Fed postponing rate hikes would cause USTs to rally. Short-term USTs have rallied, but 30-year USTs have sold off sharply. Much of the UST bond selloff reflects spillover from Europe, but Mr. Leech proposed two other explanations. The first focuses on the fundamentals.

According to Mr. Leech, "While part of the rich valuations of USTs could be attributed to their relative attractiveness to other developed markets, part was also driven by fears of deflation late last year (thanks to plunging oil prices), fears of European recession, the slowdown in China, a potential Greek exit and even the Ukraine conflict."

Since then, he observed, oil prices have stabilized, European growth looks better, Chinese authorities are rushing to provide stimulus, and the truce in Ukraine is holding.

"These developments explain some of the retracement of bond prices from their winter gains."

A second explanation is that once this downward price move was initiated, position unwinds, particularly in Europe and among leveraged players, led to outsized price and volatility moves.

"Understanding the potential parameters of this situation is mostly guesswork," Mr. Leech explained. "The dynamics of market position unwinds suggest further turbulence, particularly if fundamentals worsen at the same time."

Mr. Leech and the Western Asset team lately have become more concerned with uncertainty.

"Given the enormity of current policy experimentation, it is imperative to be modest in forecasting macro outcomes," he wrote. "We thought our risk budget was best allocated to non-UST sectors because they came under pressure as fears of deflation rose."

"We did not initiate short positions on USTs as we felt any increase in yields would be a long time coming. We also did not hedge out our below-investment-grade quality spread positions, leaving portfolios mildly 'optically' long. Our feeling was investors buying oil bonds were counting on oil company management teams and oil prices. If hedged, the 'soft duration' would suffer both ways during a period of risk, let alone a recession."

Mr. Leech concluded that, looking back, not seeing value in USTs was correct, but underweighting UST duration and fully hedging spread sectors would have been better.

"With long bonds above 3 percent, the opportunity to add UST duration to our portfolio is apparent," he advised. "Valuations, while not exceptional, are compelling and USTs have particular merit as a diversifying asset. The most dangerous risk to spread product positions is a downturn in growth or inflation. In the low growth, low inflation world we currently live in — and as we have seen so often over the past 5 years — this risk cannot be ignored."

Still, Mr. Leech believes savvy investors can identify strong opportunities in these markets.

"The unusual steepness of the yield curve presents an attractive entry point," Mr. Leech wrote. "Recent market activity has led to an 80-bp spread between 10- and 30-year USTs. Furthermore, long UST bond yields are substantially higher than other developed market long yields."

 

About Kenneth Leech

Ken Leech is Chief Investment Officer of Western Asset Management Com­pany. He joined the firm in 1990. From 1991–2014, assets under manage­ment grew from just over $5 billion to $466 billion. Mr. Leech leads the Global Port­folio, US Broad Portfolio, and Macro Opportunity teams. From 2002–2004, he served as a member of the Treasury Borrowing Advisory Committee. In 2014, Mr. Leech and the Western Asset team were named Morningstar's US Fixed-Income Fund Manager of the Year for the Western Asset Core and Western Asset Core Plus Funds. He was inducted into the Fixed-Income Analyst Society Hall of Fame in 2007. Mr. Leech is a graduate of the University of Pennsylvania's Wharton School, where in four years he received three degrees, graduating summa cum laude.

About Western Asset

Western Asset Management is one of the world's leading fixed-income managers with $455 billion in assets under management as of March 31, 2015.  The firm is a wholly owned, independently operated subsidiary of Legg Mason, Inc. LM From offices in Pasadena, Hong Kong, London, Melbourne, New York, Sao Paulo, Singapore, Tokyo and Dubai, the company provides investment services for a wide variety of global clients, across an equally wide variety of mandates. To learn more about Western Asset Management, please visit www.westernasset.com. 

About Legg Mason

Legg Mason is a global asset management firm with $707 billion in assets under management as of April 30, 2015. The Company provides active asset management in many major investment centers throughout the world. Legg Mason is headquartered in Baltimore, Maryland, and its common stock is listed on the New York Stock Exchange LM.

 

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Morningstar Award: Awarded to Ken Leech, Carl Eichstaedt, and Mark Lindbloom for Western Asset Core Bond Fund (WACSX) and Western Asset Core Plus Bond Fund (WAPSX) named Morningstar 2014 U.S. Fixed Income Manager of the Year, United States of America. Morningstar Awards 2015 © Morningstar, Inc.

Morningstar Fund Manager of the Year award recognizes portfolio managers who demonstrate excellent investment skill and the courage to differ from the consensus to benefit investors. To qualify for the award, managers' funds must have not only posted impressive returns for the year, but the managers also must have a record of delivering outstanding long-term risk adjusted performance and of aligning their interests with shareholders'. The Fund Manager of the Year award winners are chosen based on Morningstar's proprietary research and in-depth evaluation by its fund analysts.

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Yield Curve

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Federal Reserve Board

The Federal Reserve Board ("Fed") is responsible for the formulation of policies designed to promote economic growth, full employment, stable prices, and a sustainable pattern of international trade and payments.

Duration

Duration is a measurement that signals how much the price of a bond is likely to fluctuate when there is a change in interest rates. The higher the duration number, the more sensitive a bond will be to interest rate changes.

© 2015 Legg Mason Investor Services, LLC, member FINRA, SIPC. Western Asset Management, and Legg Mason Investor Services, LLC, are subsidiaries of Legg Mason, Inc.

Views expressed are not intended to be a forecast of future events, a guarantee of future results, or investment advice. Predictions are inherently limited and should not be relied upon as an indication of actual or future performance. As a result, Legg Mason cannot guarantee the accuracy or completeness of any statements set forth in this article. All information was current at the time of this publication and is subject to change without notice. This article should not be deemed as an offer to sell or a solicitation to buy the securities mentioned in this article.

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SOURCE Legg Mason, Inc.