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Good bonds sometimes have more fun (Go back and read December Insights)

| March 09, 2020
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Good morning / afternoon.  I hope that the end of winter – beginning of Spring season is going well for you and your’s.

This will be a short and sweet edition of Insights.  If you want in-depth analysis, go back and read the December 12, 2019 edition of Insights (link below):

https://www.vickerycreek.net/blog/dont-let-the-cheerleaders-down-out-the-credit-market-signals

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I hope this brings some clarity and comfort to you.

Good bonds are awesome.  Holding winners and selling losers works.  

This is from a note I sent clients on Friday, February 28'th, 2020.

"I wanted to take a moment to say hello and to weigh in and give you my two cents on current market action and some of the headlines.

1) We are heavily invested in fixed income (bonds:  both corporate credit and municipal credit), on purpose at this point in an 11 year cycle;

2) I do a lot of credit research analysis to try to make sure that we're not paying too much for investments and that the coupons and yields we obtain are above market average (in many cases significantly higher), are of very good value, and are appropriate from a risk / reward standpoint;

3) I'm keenly aware of trying to avoid putting too much money in any one investment (issuer risk management);

4) We de-risked a lot back in January 2018 because I felt strongly that organic earnings (not from financial engineering and cute, share-buyback-float-management), had roughly peaked; notably, as of Q1 2020, net, after-tax earnings are roughly flat now compared to Q1 2018;

5) The stocks we currently own seem reasonably 'recession-priced' to me and with another 5-20% drop, I may (emphasis added:  'may'), begin to add to existing half-weighted positions;

6) Negative interest rates before Mar 2022 are very possible in the USA;  by way of update, both the 10 year U.S. Treasury (1.19%) [update:  0.41% (3-9-20)], and the 30 year U.S. Treasury (1.69%) [update:  0.85% (3-9-20)], have made historic lows;

7) The Federal Reserve will likely lower the Fed Funds rate before June by 50 bps or more;

8) We could see emergency loan programs to 'prop up' industries that are hard hit from a possible forthcoming global recession; we could also see coordinated global central bank programs before too long;

9) We had an already OVER-valued stock and bond market on our hands BEFORE this virus situation;

10) Emphasizing liquidity of investments and access to cash for current, household and business operating needs may be paramount throughout the rest of 2020;

11) I don't see how the recovery off of this leg down can be V-shaped; seems to me likely to be U-shaped or even L-shaped; as I've said for years now, low interest rates will not encourage borrowers to borrow at certain points in the cycle, and certainly due to the current level of gargantuan over-indebtedness; it'll be like central banks pushing on a string (think Japan's monetary experience);

12) This correction will prove to be opportunistic for those of us who are patient, who have discipline in the things they buy (and are unwilling to buy it at any price), and can wait and not rush;

13) Like you, I'm concerned about the Coronavirus, and strains like it, possibly being something that stays with us for some time and could possibly change the way we all think about travel and commerce, etc; it also could be much, much less severe, who knows, but seems wise to take it seriously;

14) The WSJ has a good piece today called 'The Fed can't inoculate the economy';

15) Your portfolios will continue to generate generous amounts of income as the markets try to figure out what the range of price-discovery is for each traded security out there;

16) It's possible that this is not the 'real' correction yet; the reason I suggest that this is possible is because credit spreads are only gapping out in the really risky credits (CCC's); other credits (companies and municipal issuers), that SHOULD be selling off are not yet; they could still in this current down-draft, but they really haven't yet so we could have sort of a reflexive risk-on rebound predicated on the idea that the Fed can step in and help in a substantive way; I have serious doubts, but making a crystal-clear call on that prediction?...that's above my paygrade.”

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This is a chart of the 10 year UST from March 1997 when I first entered this business through last Friday.  And by way of update this morning's 10 year UST is at: 0.41% and NOTABLY the 30 year UST is at:  0.852%):

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Please re-read what I wrote on December 12'th, 2019 Insights (link below):

https://www.vickerycreek.net/blog/dont-let-the-cheerleaders-drown-out-the-credit-market-signals

Always sell bad bonds

By way of update since December:  The week that the S&P 500 was off over -11%, most of our portfolios were off -1.6% (approx).  I've been waiting for a complete re-pricing of risk assets.  The two speculative energy bond positions we added last year were sold on February 21’st and 27’th, 2020:  1) Whiting (6.25% ’23), and 2) Pride (owned by Valaris (6.875% ’20)).  Whiting will not be able to survive and Valaris may not.  The destruction to the already much-distressed, oil-price-sensitive sectors will be severe.  It is fairly clear that the default cycle part of the credit cycle is accelerating.  This will create opportunities in other sectors of the credit markets (not even related to energy), just like it has in every credit cycle since the beginning of high yield bonds and certainly as recently as:  2008, 2014 (last time Saudis tried to gain market share in a BIG way), 2016, and 2018. 

As I’ve been saying for some time, it’s the credit markets that matter the most as they’re WAY larger in size than equity markets and it’s the credit markets that furnish lines of credit and financing terms and when that’s not running smoothly, there’s a problem.

At this late point in the cycle, please don't pay so much attention to lagging indicators like unemployment rates.  Leading indicators matter and in simple terms, certainly, people not congregating together as much as they did in the past matters.

Please also remember that the word ‘recession’ is part of the regular economic cycle; it’s not a four-letter word. 

So...just lowering the Fed Funds rate is gonna help the private credit market situation?

"So those talking about how lower interest rates will save the day, are only looking at the government market.  For the private sector, this is irrelevant."  David Rosenberg - Rosenberg Research - March 9, 2020

This means that just because the U.S. government can borrow 10 year money at 0.41% (as of 3-9-20), BB rated firms (not in the energy space), can roughly borrow short term-intermediate term money at 5.2% (such a ballpark estimation; doesn't take into specific, individual credit criteria; simply an aggregate expression; see the YoY corporate bond yield chart below).  Note that the recent spike-ish move coincides with our current risk-off period.

Buckle up

I remember distinctly back in 2009, investing in International Paper and Alcoa Senior corporate bonds and getting 10.5% & 12.5% respectively.  Those bonds are still available to buy, but you’d obtain only a 1.4% and 3.6% yields respectively today.  We may not see that level of distress this recession, but we could.  So that means, if bond prices only retrace half of that price distance, then, in simple terms, “buckle up”; if you’re not 'buckled up' already.

This will be opportunistic.  But as I said in December, some passive indexes could easily go down 30% or more and not bat an eyelash.

Look at where yields are now and the global recession has just started, it’s not ending; so let that sink in.  

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Delta Airlines example

This is a credit profile snippet page for Delta Airlines.  We have some of their bonds maturing this week and it's very timely to be able to put money back to work in this environment.  Do you think you can just buy any Delta bond and not research it, talk with credit analysts/traders about it?  Well, you could, but this past weekend Lufthansa asked their government for money.  Think it can't happen to Delta?  Ask retired pilots in Atlanta.  Plus, most of their debt is front-end tapered as you can see from the graph.

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Here's some simple, current, bond advice that should keep you out of trouble:

1) Avoid all private placement debt, leverage loans;

2) Avoid CCC stuff (those default rates could approach 10% before the end of the trough in the current credit cycle (just a guess based on what dynamics I observe));

3) Avoid low-coupon, highly leveraged, highly-rated corporate credit (don't miss the highly-rated notation), because in my mind it should not be rated so highly; 

3) Focus in on BB- to A- rated stuff with reasonable coupons, reasonable leverage ratios, and reasonable dividend payout ratios;

   a) You're not being compensated for the risk you are taking but think you're not taking:  Exxon (Aaa / AA+), 2.275% to 8/16/26 yielding 1.8%; XOM as issuer: $47 Billion in outstanding debt (they should cut their dividend in half), and price of oil's dropping like a stone;

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Always be thinking about this season-next season; not just what worked last season

This next season of successful investing will require serious thinking, wisdom and not simply cute, quant-factor investing which is a bubble.  Not my word; Marko's word (see below)...

“People talk about a bubble.  The bubble is expressed in equity factors…We caution investors that this bubble will likely collapse, i.e., this time is not ‘different”.  February 20’th, 2020 - Marko Kolanovic – JP Morgan Strategist.

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Have a great day and thank you so much for your interest in how we can help you.

Yours,

Jack Parsons CTFA, AEP

President & Chief Investment Officer

Vickery Creek Capital Management, LLC

Sources:  St. Louis Federal Reserve, NY Fed Research & Statistics Group, Blackrock, CNBC, Bloomberg, Rosenberg Research, Jeffrey Gundlach, Hedgeye cartoons, Vickery Creek Capital Management, LLC, iR Research LLC, Barron's, Fidelity Institutional Wealth Services

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