January 2019

Pensions: Don’t Repeat Mistakes of the Past

Posted on January 30, 2019 by Sage Advisory

In 2019, by most accounts, corporate defined benefit (DB) plans are pretty well-funded. Their equity allocations benefited from the 10-year bull market, and their liabilities have come down as interest rates have risen from their post-crisis lows. Higher assets plus lower liabilities equals better funding levels.

But since these favorable conditions will not last forever, the prudent next step is for plans to lock in their high funding levels. In other words, prepare now for the next downturn.

The 2008 Financial Crisis devastated the pension industry, partly because many well-funded plans were too heavily weighted toward risky assets. Since the crisis, corporate plans have done a good job repairing their level of funding. The Milliman 100 Pension Funding Index, which projects the funded status of the 100 largest U.S. corporate DB plans, ended 2018 at roughly 90% funded. But 2018 also provided evidence that markets can reverse quickly. Equity markets suffered double-digit losses, and the Milliman index dropped 4.5% from its peak in September.

Source: Milliman, as of 12/31/2018

Even though most corporate pension plans lost ground in the fourth quarter, it’s important to note that the Milliman index, at 90% funded, is still 20% higher than it was in August 2010. For plans that have successfully rebuilt their funding, we recommend a shift from capital-appreciation mode to capital-preservation mode. This means reducing allocations to risk-seeking assets (such as equities) and transitioning to more liability-driven investments.

Sage tailors liability-driven investment portfolios to the specific liabilities of DB plans. That means no two LDI portfolios are identical. Well-designed LDI strategies should keep duration and volatility levels in-line with their liability benchmarks and serve as effective hedges against interest rate risk. As interest rates rise or fall, LDI portfolios should minimize volatility of the plan’s funded status.

For plans that choose not to hedge against market volatility, the result could be larger required contributions during the next market downturn. It is not a question of if, but when.

Disclosures: This is for informational purposes only and is not intended as investment advice or an offer or solicitation with respect to the purchase or sale of any security, strategy or investment product. Although the statements of fact, information, charts, analysis and data in this report have been obtained from, and are based upon, sources Sage believes to be reliable, we do not guarantee their accuracy, and the underlying information, data, figures and publicly available information has not been verified or audited for accuracy or completeness by Sage. Additionally, we do not represent that the information, data, analysis and charts are accurate or complete, and as such should not be relied upon as such. All results included in this report constitute Sage’s opinions as of the date of this report and are subject to change without notice due to various factors, such as market conditions. Investors should make their own decisions on investment strategies based on their specific investment objectives and financial circumstances. All investments contain risk and may lose value. Past performance is not a guarantee of future results.

Sage Advisory Services, Ltd. Co. is a registered investment adviser that provides investment management services for a variety of institutions and high net worth individuals. For additional information on Sage and its investment management services, please view our web site at www.sageadvisory.com, or refer to our Form ADV, which is available upon request by calling 512.327.5530.

Sage is in the “No More Rate Hikes” Camp

Posted on January 22, 2019 by Kari Edgar

While investors have focused on the recent stock market recovery, one important development has largely been overlooked: the end of the Fed’s rate-hike cycle.

According to the current probabilities implied by federal funds futures prices*, the target federal funds rate will likely remain unchanged between now and January 2020. The market gives that scenario better than a 70% probability. The likelihood of another hike is around 30% through the fall, after which it becomes increasingly likely that rates will actually decrease.

Source: Bloomberg

Recent public communications by Fed board governors and bank presidents also suggest Fed policy has entered an extended pause, despite the FOMC’s dot plots continuing to project additional hikes this year.

Sage is currently in the “Fed is done” camp. We see mounting evidence that the U.S. and global economies are slowing, and fundamentals in Corporate America are deteriorating. As these trends continue, further hikes will become increasingly unlikely.

When will the Fed raise rates again? For the first time since the financial crisis 10 years ago, the answer is, “probably not until after the next recession.”

* Source: Bloomberg, as of 1/18/2019.

Energy’s Sharp Rebound Reflects Dramatic Sentiment Shift

Posted on January 18, 2019 by Sage Advisory

While a further rally in risk assets and a compression in credit spreads will require a follow-through by the Fed as a well as cooling of trade tensions, the Fed has done its part to quell market volatility to start off 2019. One sector that has had a particularly strong rebound is Energy.

Atlas Shrugged, Powell Paused

In his December press conference, Federal Reserve Chairman Jerome Powell dismissed market concerns over further interest rate hikes, roiling an already troubled equity market. The result was one of the worst months for risk assets in recent memory – the S&P 500 suffered the worst December since the Great Depression. Credit markets also experienced a massive negative turn in sentiment and price performance. Investment grade credit spreads closed the year at 153 basis points, nearly 50 basis points higher than the closing level on September 30.

Just a few weeks later, on January 4, Powell spoke on a panel with former Fed Chairs Janet Yellen and Ben Bernanke at the American Economic Association conference. His remarks reflected an about-face from his December press conference.

Notably, Powell stressed flexibility in Fed policy: “We’re always prepared to shift the stance of policy and to shift it significantly if necessary;” and, we’re: “Listening sensitively to the message that markets are sending;” and on the potential to pause its rate hike as well as balance sheet runoff, he said: “We will be prepared to adjust policy quickly and flexibly and to use all of our tools to support the economy.” The Fed then bolstered its messaging around a hiking pause this week when speeches from Fed officials Charles Evans, Loretta Meester, and Eric Rosengren echoed a similar tone.

Financial stability and markets are now squarely and explicitly in the Fed’s crosshairs, and a dour market mood turned around on a dime. Credit markets have snapped back. Investment grade corporate spreads, which peaked on January 3, the day before Powell’s speech, have compressed by 9 basis points (Chart 1). More notably, high-yield credit spreads have fallen by 92 basis points, which retraces most of December’s move (Chart 2)!

Energy Leads the Charge Higher

The Energy sector has seen a particularly strong rebound in both spreads and sentiment, bolstered by a rebound in the benchmark West Texas Intermediate Crude Oil price from a low of $42.53 on December 24, 2018 to $52.02 on January 11, 2019.

Energy sector BBB spreads compressed nearly 20 basis points following Powell’s comments, but perhaps the most notable development was the reopening of the high-yield new issue market by natural gas pipeline operator Targa Resources (NYSE: TRGP). Targa priced the first high-yield bond issuance this year, the first since December 11, 2018. Prior to this deal, the high-yield new issue market had been effectively closed for a month due to extremely poor sentiment surrounding risk assets.

It’s significant that the volatile Energy sector was the home of the first company to break the drought. So strong was the demand for this speculative new issue that Targa was able to garner $1.5 billion in bond proceeds, twice the planned initial amount. The new bonds have performed well thus far, trading 2 points higher and nearly 40 basis points tighter in spread since issuance.

It’s significant that the volatile Energy sector was the home of the first company to break the drought. The fact that an energy company had a successful issuance speaks volumes of where sentiment is headed. It also confirms the idea that expectations for global demand growth are perhaps turning more positive.

5 Reasons to Favor Core Fixed Income in 2019

Posted on January 11, 2019 by Sage Advisory

Higher Volatility. Even after factoring in some spread widening during the year, Sage believes 3% to 4% return is easily achievable for core fixed income. And with equity return expectations below average, in the 5%-to-6% range, and accompanied by greater downside risks and high volatility, fixed income is the more attractive asset class from a risk-reward perspective going into the new year.

Equity Volatility (VIX) 3-Month Average

Higher Yields. For income seekers, yields on diversified core investment grade fixed income are now 3.25%, up 60% from just three years ago, and are now well above equity dividend yields. This should add some stability to returns. For more risk-averse investors, with the curve flattening, short-duration strategies now offer attractive yield with limited interest rate risk.

Core Bond and Equity Yields

Source: Bloomberg

The End of the Fed cycle. Unlike equities, which experienced a deteriorating picture into year end, bond investors enjoyed improving returns throughout the year, with the Aggregate Index posting better returns each subsequent quarter. This is not an unusual pattern, as bond returns are typically higher into the end of a Fed cycle, as investors reap the benefits of higher yields and long rates stabilize in anticipation. The environment improves further for bond investors post-Fed cycle, with returns for the 12 months following the end of a Fed cycle almost double the longer-term average.

Core IG Bond Returns: Long-Term vs. Post-Fed Cycle

Source: Bloomberg. Average post-cycle includes the last six Fed cycles, and long-term average is since 1985.

Equity Headwinds/Earnings Peak. Equities face greater macro headwinds relative to bonds at this point in the form of decelerating global growth and earnings, tightening liquidity from central banks, and a host of geopolitical tail risks. If earnings have indeed peaked for the cycle, the rollover process has not historically been pleasant for equity investors.

S&P 500 12-Month EPS

Source: Bloomberg

Macro Risks Point to High-Quality Core Fixed Income Outperformance. Generating returns in fixed income will not come without its challenges, however, as some of the same headwinds causing a more bearish outlook for equities are also likely to impact credit spreads and the riskier segments of the global bond market. Tightening liquidity conditions, declining earnings growth, and growing recessionary concerns is not the most supportive backdrop for credit spreads, and we expect widening pressures throughout 2019, especially among the lower-quality tiers. This suggests the best returns for 2019 are likely to come from higher-quality core fixed income. This view is also supported by our post-Fed cycle return analysis, which shows that while historically all major bond segment returns are higher post-Fed cycle, the advantage of credit over Treasury returns is diminished and core IG outperforms high-yield.

Bond Returns: Long-Term vs. Post-Fed Cycle

Source: Bloomberg

Notes from the Desk: Municipal Bonds — The Turtle That Keeps On Winning!

Posted on January 8, 2019 by Sage Advisory

Both classic and modern literature have countless stories of seemingly outmatched opponents finding a way to persevere and even prevail, despite the odds. One of our favorite examples, especially since we are talking about municipal bonds, is Aesop’s Fable “The Tortoise and the Hare” in which the slow and steady Turtle unexpectedly wins a race against the seemingly unbeatable Hare. Despite both literary and real-life examples of these events occurring time and time again, social influences, behavioral factors, and cognitive distortions cause many investors to keep betting, or in this case, investing in the proverbial “Hare.” Although adjectives like steady, stodgy, and plain-vanilla do not elicit a rousing response, municipal bonds continue to provide investors with positive returns, low volatility, and steady tax-free income.

Once again in 2018, the municipal market showed its merit and provided investors with positive returns, low volatility, and ample liquidity during a time when it was needed most. Despite a quarter or two of low or negative returns earlier in the year, municipal bonds finished 2018 in positive territory as most other core asset classes experienced significant challenges, as shown below:

Market Environment

Source: BarclaysLive and Bloomberg as of 12/31/18

Despite the recent tumult of the global equity and corporate credit markets, municipal bond volatility was much more muted in comparison to the U.S. equity market, further validating municipal bonds’ role as a negatively correlated asset class that financial advisors and clients rely upon during times of market turmoil.

Market Volatility Comparsion (% Chg from 11/30/18 to 12/31/2018)

* VIX Index for Equity Vol, Move Index for Muni Vol, adjusted with daily M/T ratio

Furthermore, municipal bonds not only provide attractive income on a tax-free basis, but they also accomplish this objective with significantly less risk. An often-overlooked measure of income generation efficiency is risk-adjusted income. Relative to other income-producing asset classes, municipal bonds generate higher levels of income per unit of risk, particularly versus equities, which display pre-tax yields. This is illustrated in the chart below:

Market Yield and Risk-Adjusted Income

Source: BarclaysLive and Bloomberg as of 12/31/18, Agg & HY yield tax-adjusted at 35%

Despite the inherent benefits of municipal bonds, naysayers will continue to belittle the fixed income Tortoise and praise the equity Hare. For 2019, Sage is betting on the Tortoise.