Changing Liquidity in the Fixed Income Markets

by Brad Houle, CFA Executive Vice President

The bond market is a dealer market with no central exchange. This means that all bond trades are over-the-counter trades whereby market participants trade amongst themselves. By contrast, stocks are traded in a continuous auction market where an investor can get the market price of a stock instantly by seeing where it is trading on the various electronic and physical exchanges. Bond pricing can be more esoteric, particularly for more exotic securities such as some mortgage-backed bonds or high-yield bonds.

The 2008 financial crisis was sparked by speculative mortgage-backed securities which started to fail when homeowners stopped paying their mortgages. Part of the issue was the fact that it was difficult to nearly impossible to value these securities and there was no liquidity for these bonds. The government often regulates in response to the last crisis and this situation is an example of backward looking regulation. As part of the reactive financial market regulation that came out of the financial crisis was that banks are now required to have greater regulatory capital. On the surface this seems like a good idea: banks are required to hold more "safe" assets on their balance sheets like U.S. Treasury bonds to cushion for inevitable bumps in the road. The unintended consequence of this change has made it difficult for large banks to effectively trade fixed income securities. It used to be good business for Wall Street banks to trade bonds with customers. Banks would make a market in bonds and would use their balance sheet to provide liquidity to customers. With onerous capital requirements this business has become difficult and unprofitable for participants. The bond market has gotten much bigger since the financial crisis and much less liquid.

According to the Wall Street Journal, since the 2008 financial crisis the U.S. Corporate bond market has doubled in size to $4.5 trillion dollars. In addition, outstanding U.S. Treasury Bonds trading volumes have fallen 10 percent since 2005 while the size of the market has tripled.

The implication for this change is volatility in the bond market will probably be higher going forward. We have yet to have a real test of bond market liquidity since financial crisis. When interest rates start to climb we will see how resilient the market is when short-term investors in bonds all try to squeeze out the same small door at the same time.

The good news for Ferguson Wellman clients is we largely use individual bonds for clients. This is important because an investor that owns an individual bond can wait out the pricing volatility because at maturity you will get your money back. Participating in panic selling into a volatile or potentially illiquid market is completely voluntary. In the past, we have been able to be opportunistic buyers of bonds sold into illiquid markets. One case in point was the mini-crisis in the municipal bond market when an analyst named Meredith Whitney unwisely used her fifteen minutes of fame on the television program 60 Minutes to incorrectly predict massive defaults in the municipal bond market.

Another silver lining to this potential situation is an advance in technology that could improve liquidity in the fixed income markets. The leading edge of fixed income trading is an electronic bond trading platform that has the potential to revolutionize bond trading. Rather than use a bond dealer intermediary to trade bonds, this platform allows firms like Ferguson Wellman to trade directly with other investment management firms. This concept is in its infancy and Ferguson Wellman is adopting this technology where it can benefit our clients’ portfolios. We are optimistic that wide adoption of this technology can benefit all fixed income investors.

Our Takeaway for the Week

• A lack of liquidity in the bond market may cause volatility in bond prices to be elevated in the future. Owning individual bonds can allow an investor to ride out any potential storms. Also, we think that an eventual broader adoption of electronic bond trading technology will eventually make markets function more smoothly.

Disclosures

Lazy Hazy Crazy Days

by Ralph Cole, CFA Executive Vice President of Research

Although this time of year is often described as the summer doldrums, that certainly was not the case this week. Earnings, the Fed and economic data dominated the tape … and made for interesting market activity.

All Along the Watchtower

Fed-watching during a time of taper is an essential part of managing money these days. The Federal Open Market Committee (FOMC) announced on Wednesday that they would continue to taper their purchases of Treasuries and mortgage-backed securities by an additional $5 billion each this month. The Fed continues on pace to stop all security purchases by October. While they made mention that there is still slack in the labor market, the Fed must be comforted by the consistency of job growth in 2014. The U.S. has added an average of 230,000 jobs per month this year versus 194,000 per month in 2013. Commentary after their two-day meeting continues to signal that they are on pace to begin raising rates in the middle of 2015.

Too Hot?

The Bureau of Economic Analysis reported that U.S. GDP grew 4 percent during the second quarter. This robust growth and some of the comments by the Fed may have spooked investors this week into thinking that the Fed will raise rates sooner than expected. We believe this was more of an excuse for a sell off rather than a good reason for selling stocks. There will be volatility in the stock market as we move into next year and the Fed communicates their outlook. In the end, we believe that they will be raising rates for the right reasons … the economy is getting better and extraordinary stimulus is no longer needed.

Upside Down

Earnings season is always one of the more volatile times of the quarter. While earnings have come in very strong (7.7 percent growth up to this point), seemingly minor misses are punished unmercilessly. The healthcare sector has provided the biggest positive surprise for the quarter. Thus far, healthcare companies have reported 14.8 percent growth. On the other end of the spectrum, consumer discretionary companies have only reported 2.9 percent earnings growth.

Our Takeaways for the Week

• Focus on the Fed will continue to cause volatility in the market in the coming months. We believe it is more important to focus on the overall trajectory of the economy to determine direction of the stock market
• Companies continue to grow earnings at an impressive rate despite sub-par global growth

Disclosures

What to Expect When You Are Expecting a New Fed Chair

by Brad Houle, CFA Senior Vice President

Ben Bernanke’s tenure as Fed Chairman is coming to an end this year. He became Fed Chairman in 2006 and led the organization through the financial crisis. Prior to his tenure as Fed Chairman, he was an economics professor at Princeton University. One of his primary areas of interest was the Great Depression and that perspective shaped the Federal Reserve’s response to the crisis.

Janet Yellen has been nominated as the next chair of the Federal Reserve Open Market Committee. She is expected to be confirmed and would start to serve her term in early 2014. The financial markets are in favor of a Yellen Fed in that her viewpoint is thought to be similar to the outgoing Ben Bernanke. She is characterized as being “dovish” which means that she is in favor continuing zero interest rate policy and quantitative easing for an extended period of time until unemployment is reduced to a more acceptable level. Financial markets crave as much certainty and continuity as possible and the Yellen Fed fits the bill. She was tasked by the outgoing Chair Bernanke to facilitate a more open and transparent Fed. It is expected that Yellen will use this platform to steer expectations of market participants.

Countless articles and endless analysis of the Yellen Federal Reserve in the financial press have debated the minutia and theorized what a Yellen Fed will be like. At Ferguson Wellman, we have a unique perspective on the Yellen Federal Reserve. Jim Rudd, CEO of Ferguson Wellman, had the opportunity to serve as the Chair of the Portland Fed for several years under Janet Yellen who was then President of the 12^th District of the Federal Reserve of San Francisco. Having witnessed her management skill first hand, Jim commented that she embraces the culture of the Fed and has the ability to manage the process of setting monetary policy. He also indicated she was on the front line of the real estate crisis in the Fed 12^th district during the Great Recession and that had a lasting impact on her and how she views the fragility of the recovery.

Takeaway This Week

• There were not a lot of surprises from the Fed minutes released on Wednesday. The only material change was language surrounding an acknowledgement of a slowing in the housing recovery

Disclosures

Fannie and Freddie's Fate

by Brad Houle, CFA Senior Vice President

There was plenty of controversy this week in Washington with the government shutdown and the looming deadline for raising the debt ceiling. However, there was another controversial situation at play that has been pushed further off into the future. Fannie Mae and Freddie Mac are government sponsored enterprises that guarantee and securitize mortgages for U.S. homeowners. These entities perform an important function in the U.S. economy by guaranteeing the payment of principal and interest and securitizing or “packaging” mortgages for sale to institutional investors. Americans will recall that Fannie Mae and Freddie Mac both got into financial distress during the financial crisis due to excessive leverage and lax underwriting standards. As a result, the U.S. government had to step in and take Fannie Mae and Freddie Mac into conservatorship in September of 2008.

Fannie Mae and Freddie Mac have now been stabilized and have actually been returning robust profits. Specifically, since 2011 they have paid back $131 billion in dividends to the U.S. Treasury of the $187 billion bailout they received. Fannie Mae and Freddie Mac have long been viewed as an uneasy mixture between a private enterprise and a public entity. Recently there have been legislative attempts to eliminate Fannie Mae and Freddie Mac as we know them. The current administration believes that private capital should play a larger role in the mortgage market.

Investors in mortgage-backed securities issued by Fannie Mae and Freddie Mac rely on the implied government credit guarantee. If that is removed, the cost of mortgages is estimated to rise by one to two percentage points. As such, investors will demand a higher return to own mortgage-backed bonds with a greater risk that interest and principal will not be repaid. In a housing market that is still recovering from the financial crisis, an increase in mortgage rates due to this change would hamper the pace of economic growth.

What will actually happen is still very much up in the air. One thing that is virtually certain is the payoff of Freddie and Fannie debt obligations. To back off the current guarantee would throw financial markets and especially the mortgage-backed securities market into turmoil.

Takeaways

• The evolution of mortgage financing and the eventual fate of Fannie Mae and Freddie Mac is a political controversy that does not have a simple private market solution

Disclosures