Author: Sage Advisory

Notes from the Desk — Fed Support Creates Strong Risk-On Environment

Posted on by Sage Advisory

To help restore liquidity and reduce panic among investors at the depths of the coronavirus crisis, the Federal Reserve enacted several measures in late March. One such step was the implementation of a corporate bond buying program. The $750 billion facility was originally intended to only allow for purchases of bonds from companies that could attest that they were under severe stress, so few companies opted in.

Despite the requirements of the program, credit spreads retraced most of the move wider from March, to settle in the 140 bps to 150bps range, well within the long-term average range.

And the funding costs of corporate borrowers are now actually lower than before due to a dramatic decrease in rates because of the resumption of quantitative easing. Consequently, the average coupon rates of investment grade bonds now sit at 3.89%, well below levels seen in February prior to the COVID-19 shutdowns.

With credit markets stabilized and lower funding costs for IG borrowers, bond investors have moved back into “risk on” mode.

Curiously, the Federal Reserve decided to dramatically expand the scope of its corporate bond buying program on June 15, well after markets had stabilized. The Fed indicated that the goal was to ensure corporate borrowers could access the primary markets for funding, but that goal had long since been accomplished. Why then did the Fed decide to drastically increase the size of the program by eliminating the need for companies to self-identify as “distressed?” The answer may lie in a more esoteric part of the credit markets that is typically the domain of investment bankers.

Bridge Loans

Bridge loans are typically non-public loans with shorter maturities that are designed to “bridge” the gap between an M&A event (e.g., a large acquisition) and the pricing of public bonds in the primary market that will finance the debt portion of the M&A event. These loans are usually syndicated by a small group of investment banks that each agree to provide some portion of the funds in exchange for substantial underwriting fees.

The bridge loan is used as a necessary short-term source of funding necessary to get the deal done, and typically the borrower will issue bonds a later date after a deal “roadshow” to allow public bond investors to become comfortable with the credit profile of the combined entity. In exchange for this short-term funding, borrowers will typically pay banks steep fees and higher interest rates than would be typical for such a short duration loan (usually one year or less). Consequently, this is a very profitable business for large investment banks.

The downside for the banks is the unlikely scenario where the bridge loan becomes “hung.” This refers to when a deal is agreed upon and bridge financing is secured, but between the normally short period where the bridge loan is funded and when the borrower can successfully launch a new primary bond issue the credit environment changes materially. This situation perfectly describes several large bridge loan deals that were funded with the year prior to February 2020. Without strong enthusiasm for high-yield credit risk, several of these deals would not have been able to price high-yield bonds to take out the bridge financing and the investment banks that participated in the bridge deal would be left with illiquid, stressed loans to credits that could not re-finance their short-term debt in favor of longer-dated high-yield bonds.

The following is a list of some high-profile syndicated bridge loans that would likely have ended up “hung” without help from the Fed’s liquidity infusion. These deals in aggregate account for tens of billions of dollars of credit risk for investment banks, a situation that could have easily soured the balance sheets of these banks with little recourse.

T-Mobile-Sprint

  • Size: $19bn
  • Structure: Covenant-light bridge loan
  • Term: 364 days
  • Use of Proceeds: To finance the acquisition of Sprint
  • Banks Involved: Barclays, Credit Suisse, Deutsche Bank, Goldman Sachs, Morgan Stanley, RBC, US Bank, Wells Fargo, and others

El Dorado Resorts

  • Size: $1.8bn
  • Structure: Covenant-light bridge loan
  • Term: 364 days
  • Use of Proceeds: To finance the acquisition of Caesar’s Entertainment
  • Banks Involved: JP Morgan, Credit Suisse, MacQuarie

Elanco Animal Health

  • Size: $2.75bn
  • Structure: Bridge loan
  • Term: 364 days
  • Use of Proceeds: To finance the acquisition of Bayer’s animal health business
  • Banks Involved: Goldman Sachs

WESCO International

  • Size: $3.125bn
  • Structure: Unsecured bridge loan
  • Term: 364 days
  • Use of Proceeds: To finance the acquisition of Anixter International
  • Banks Involved: Barclays, US Bank

 

Implications for Investors

This action by the Fed should encourage investors to think more broadly in terms of risk allocations. A well-functioning high-yield bond and leveraged loan market points to a strong “risk on” environment for investors, and there are opportunities to invest in bonds that are still below intrinsic value despite the rally in credit spreads in April and May. Investors that may have been worried about an extreme liquidity crunch grinding public credit markets to a halt should take comfort in knowing the Fed seems prepared to do whatever is necessary to maintain liquidity and keep spread volatility to a minimum for the remainder of 2020.

 

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.

On this Milestone Earth Day, there is No Better Time to Invest in ESG

Posted on by Sage Advisory

Today marks the 50th anniversary of Earth Day, a worldwide event that recognizes our Earth’s resources are finite and deserve to be protected, and a day that jumpstarted the evolution of an investment philosophy we practice today called Environmental, Social, and Governance – ESG – investing.

Demand for ESG investments is on the rise, and the reason is simple: people want to invest in well-run companies that care about ALL their stakeholders and create a net positive effect on the environment. Companies that adhere to ESG principles and policies will outperform over the long-run – they are more sustainable. And in these uncertain times, people are reaching for what is sustainable.

During one of the worst economic shocks on record, the COVID-19 pandemic, which has been exacerbated by an oil price war, ESG investments have done better than their benchmarks.

In the first quarter of 2020, 70% of sustainable funds finished in the top half of their category across asset classes, and that was regardless of whether they were actively or passively managed, according to Morningstar.

In 2019, net flows to mutual funds and ETFs that received high sustainability ratings were $20.6 billion, almost four times net flows of $5.5 billion in 2018, according to Morningstar. Last year was also one of the best years for the S&P500 and a stellar year for fixed income, but investments that were optimized for ESG issues had even better returns.

 

Companies with higher ESG scores tend to be more profitable and have more resources to invest in ESG issues, and their earnings are less volatile. This in turn makes them better companies that are positioned to do well over the long-term.

For more on Sage ESG Investing, click here.

For more on Sage’s Sustainable Investment Policy, click here.

 

Sustainable Investing in the Age of COVID-19

As economies worldwide are reeling from COVID-19, the pandemic is shining a light on companies that truly embrace ESG principles. At Sage we will be closely watching the impact companies’ Environmental, Social, and Governance policies have during this unprecedented time. To gain a better understanding of the ESG factors that are relevant right now, we’ve provided some examples below.

(E) Environmental Impact

If there is one area that has seen some positive results as a result of the pandemic, it is the environment. Cleaner air and a decline in carbon emissions due to travel restrictions, as well as cleaner water as a result of the absence of normal boat traffic have been signs of a healthier environment. Prior to COVID-19, climate change risk concerns had been increasing among the ESG investing community and had gained greater weight in ESG analysis. Unfortunately, many of the positive environmental benefits engendered by COVID-19 have not been the result of active company management; however, they have brought awareness of climate change to audiences beyond ESG. It is our hope that once the dust settles companies will actively manage the ways they can lessen their carbon footprint, whether that be by telecommuting, less business air travel, offsetting carbon emissions, etc.

(S) Social Impact

Companies across industries are struggling to operate and are being forced to let go of employees as a result of significant losses. As of Monday, April 20, 22 million people have filed for unemployment, with the current unemployment rate inching near a whopping 18% of the U.S. workforce.

From an investment standpoint, people should be paying a close eye to the companies taking swift, supportive actions for their employees. Some franchises, major conglomerates, and even small businesses are still finding ways to pay their employees, whether through CEO pay cuts or loan payouts while their doors remain shut for now.

With “stay-at-home” orders remaining in place across the United States, working from home has become the new norm for many businesses, potentially changing the future of offices forever. Companies that support their employees during this time will be closely watched by ESG investors.

(G) Governance Impact

From managing business risk, to customer and employee relations, to implementing policies and procedures, how companies are making decisions at the executive level will demonstrate to investors who is making a difference.

We are seeing companies across industries going above and beyond to support health care workers and all essential employees. Car manufacturing companies such as Ford, Tesla and GM have mobilized, making ventilators and other medical devices for the Strategic National Stockpile. Fashion designers and luxury labels have also stepped up, helping overcome shortages of masks and other personal protective equipment (PPE) in some of the hardest-hit countries.

Taking efforts such as these during such a challenging time will demonstrate a company’s core values, and in turn, significantly boost investor sentiment (and companies that do not, may incur irreparable brand damage). The more involved and responsible companies become amid this pandemic, the higher their sustainability will be long-term.

Coronavirus relief efforts have an enormous impact on investing this Earth Day. It is evident that companies with high ESG ratings have been proactive in taking action against the pandemic. Insight into the higher-rated ESG companies shows us the values investors are seeking at this time; including trust, transparency, creativity, authenticity, and communication.

Embracing Sustainability’s Silver Linings on this Earth Day

Today’s Earth Day celebrations will certainly look different than years past; however, that does not mean we should not celebrate. Let’s continue to highlight companies that are doing all they can to continue to follow ESG policies, from protecting the environment, employees, and customers, to holding their leaders accountable to make a difference.

 

Listen to Bob Smith, President & CIO, talk with Jill Malandrino of Nasdaq TradeTalks about ESG performance amid COVID-19.

To read our recent Highlights and Holdings, case studies on companies that garner high ESG scores, see:

AbbVie

Coca-Cola

VF Corporation

Marsh & McLennan Companies

 

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.

 

 

 

Making Sense of Fed Policy During COVID-19

Posted on by Sage Advisory

The Fed’s response to the economy and market breakdown engendered by the COVID-19 crisis has been unprecedented — not only in scale, but how quickly new policy tools have been used to address rapidly tightening financial conditions. The following is a short post intended to demystify the “alphabet soup” of Fed tools and what each tool is trying to fix, and provide a list of additional policies we can reasonably expect in the near-term.

A global health crisis ultimately requires a scientific solution, but earlier this month within the span of days, the health crisis morphed into economic stress (with the uncontained spread of COVID-19 in Italy), and eventually threatened to become a full-blown financial crisis (after the OPEC oil shock on March 7). Ultimately, the intensity of the Fed’s policy tools was targeted at containing and preventing market stresses from turning into a financial crisis while the world dealt with COVID-19.

 

Notable policy tools the Fed has employed thus far include:

Interest Rates Cut to Zero

The Fed has cut rates to zero, first on March 3 by 50 basis points, and by a further 100 basis points on Sunday, March 14. As market stresses intensified effects on short-term fixed income both in the U.S. and overseas, which was caused by interest rate differentials, the FOMC had to cut rates to zero two days before its scheduled March meeting, underscoring the urgency of the situation.

Unlimited Quantitative Easing (QE)

The Fed started a $700 billion QE program on March 14, and nine days later, it expanded the size of QE to be open-ended. To put this into perspective, after the global financial crisis (GFC), the span of QE1 to QE3 took 5 years. It took only nine days for the Fed to expand QE to be open-ended. Put another way, the Fed will buy more assets this week than it bought post-GFC during the years 2010 to 2012.

 

Commercial Paper Funding Facility (CPFF)

In order to support the commercial paper market, which is a short-term funding vehicle for the corporate sector that seized up last week, the Fed announced a $100 billion purchase program backed by $10 billion of funds to cover loan losses from the U.S. Treasury’s Exchange Stabilization Fund (ESF) (typically used to intervene in foreign exchange markets).

Money Market Mutual Fund Liquidity Facility (MMLF)

On March 18, the Fed created the MMLF to lend money to banks so that they can purchase assets from money market mutual funds, supporting functioning of the money markets. Again, this program is $100 billion in size, backed by $10 billion from the U.S. Treasury’s ESF.

Corporate Credit Facility (PMCCF, SMCCF)

On March 23, the Fed created two vehicles to purchase corporate bonds in both the primary and secondary markets. Notably, the Fed announced the purchase of corporate bond ETFs. This program to buy IG corporates was truly a new tool (not used during the GFC), which has calmed credit markets in the near term. The total size of this program is $300 billion, backed by $30 billion from the ESF.

Term Asset-Backed Loan Facility (TALF)

Also on March 23, the Fed established the TALF to buy asset-backed securities that are backed by auto, student, or small business loans. The capacity of this vehicle is included in the $300 billion to buy corporates and ETFs.

 

Our takeaways and expectation for future policy:

The Fed and U.S. Treasury are in coordination, and thus, monetary and fiscal policy are one.

The Fed is in the fiscal arena now. By creating vehicles to effectively support the debt markets and make loans to businesses backed by the U.S. Treasury, the Fed is now squarely conducting fiscal policy, and we believe this trend will continue with future policy moves.

The Fed will roll out a Main Street Business Lending Program.

The Fed announced a “Main Street Business Lending Program,” the specifications of which are currently unknown, but we believe it will be of similar structure to the ESF-backed facilities mentioned previously.

These facilities and programs are going to get larger, much larger.

In the CPFF, MMLF, SMCCF, etc., the lending capacity of these vehicles are backed by capital from the U.S. Treasury. For every dollar from the U.S. Treasury, there may be 10 dollars of lending capacity. Of the announced programs, there is roughly $500 billion of lending/market support capacity backed by $50 billion of capital from the ESF. The “Phase 3” stimulus bill upsizes the ESF by $450 billion. Put a 10x multiplier on that and $4.5 trillion is the size of market support and lending capacity that would be available to the Fed. To put this into perspective, the Fed’s balance sheet is currently at $4.6 trillion after over a decade of monetary accommodation since the GFC! A $2 trillion fiscal stimulus program could have the effect of a $6 trillion stimulus program, which is over 30% of U.S. GDP! That would dwarf any stimulus deployed during the GFC by multiples.

The Fed and Treasury are truly doing “whatever it takes.”

We are optimistic that market functioning and liquidity will slowly return. The Fed and Treasury have shown a sense of urgency to support the economy during the COVID-19 pandemic and hopefully, when the virus starts to taper off, we believe we could see a material rebound in financial assets.

 

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.

Black Swans of the Same Feather – Sage Commentary on Recent Market Volatility

Posted on by Sage Advisory

The market moves in recent weeks have been nothing short of unprecedented. We seem to be experiencing multiple rare and unpredictable events simultaneously. The following is a recap of key events and our observations thus far.

A recap of last week through Monday, March 9:

  • COVID-19 concerns have grown given its spread to an increasing number of countries. The disease has now reached more than half of the countries in the world, including the U.S. This has been a major concern, and markets have priced in a hit to economic growth both from private sector demand and more uniquely, supply-side shock, as supply-chain disruptions in Asia and now the U.S. will result in a further hit to global growth. In its most recent report, the OECD revised its 2020 global growth rate assumption down to 2.4% from an already low 3% given concerns around COVID-19. The rate could fall as low as 1.5%, according to the OECD’s outlook.
  • A strong policy stimulus response was expected, and the Fed made the first move, with an emergency 50 bps rate cut on March 3. However, given that the current situation largely involves an unpredictable viral outbreak that is truly an external shock, lowering the cost of money did not have the same effect as in prior slowdowns since the 2008 crisis. In the coming weeks, the world’s major central banks and governments are expected to inject additional monetary and fiscal stimulus into the economy to combat any potential slowdown. The ECB is expected to ease policy further, either by cutting rates and/or making asset purchases on March 12, and the Fed is expected to follow suit with further rate cuts on March 18. On the fiscal side, affected countries could provide fiscal stimulus to their respective private sectors through the form of tax cuts or direct relief to affected industries – similar to what China has done over the past month for its domestic business sector.
  • In addition to the COVID-19 shock, tensions between Russia and Saudi Arabia have escalated into an all-out oil price war. In response to a breakdown in OPEC/Russia talks last week, on Saturday, Saudi Arabia announced massive discounts to its official oil selling prices and indicated that it was increasing production above the typical 10 million barrels per day. The fear of an oil price war resulted in a 25% selloff in crude oil during yesterday’s trading session – the second worst day for WTI crude on record. The selloff sent shockwaves through global markets, as any commodity-linked asset class or sector priced in an additional hit to growth on top of slowing activity from COVID-19.
  • These events occurred in the context of a market with extremely thin liquidity. Wider bid-ask spreads across all asset classes have amplified market volatility with several extreme +3% up and down days. Currently, the VIX index is trading at 55, the highest at any time since the 2007/2008 crisis.

 

Observations:

  • The collapse of Treasury yields – Treasury yields have collapsed to all-time lows as investors continue to flock to safe havens. U.S. Treasury markets are not just pricing in further Fed action, they are pricing in a total “Japanification” of the U.S. economy with long-duration yields trading well below 1% at the start of this week.

 

 

  • Widening credit spreads – Credit spreads have widened past 4Q 2018 to near 2016 levels, with the speed of the move catching investors off guard. U.S. credit markets, which before March had been resilient against virus fears, have repriced to reflect a significant economic slowdown over the balance of 2020. Currently, the U.S. high yield sector offers an all-in yield at near 8%, which could prove to be an interesting opportunity if market volatility begins to settle down as a result of positive Covid-19 breakthroughs, government policy actions, and increased investor confidence.

 

 

  • Equity performance vs. bonds – The recent relative return of global equities versus bonds has no precedent outside of the financial crisis, since right after the collapse of Lehman Brothers and AIG. The chart below shows the 1-month relative return of the MSCI ACWI vs. the Bloomberg Global Aggregate Index, which stands at -21%.

 

 

 

The Market is Pricing in a Recession – The Question is: How Deep?

At Sage, we’ve maintained a relatively low level of risk across most of our strategies and remain opportunistic. A full-scale risk-off positioning often provides an opportunity in dislocated areas of the market, but we believe it’s too early to “buy the dip” here. Markets are in “no-man’s land” in some respect, driven by a tremendous amount of uncertainty and fear.

The scenario in which COVID-19 disruption devolves into a global recession is now reflected in market pricing. The question now is how deep is it expected to be? Policymakers will respond in the coming days and weeks with monetary and fiscal stimulus, but the nature of those policies will have to somehow address the threat to the economy that is now fourfold: COVID-19 demand/supply chain shock, an oil price war, credit stress, and a lack of trading liquidity. We await that response, along with any new details, and will continue to keep you updated as this unprecedented situation develops.

 

Going Forward: Heightened Market Surveillance & Identifying Value Across Asset Classes

  • The Sage investment team is deeply experienced and has worked together through multiple cycles, including several periods of economic and market stress. During uncertain times, the structure and experience of our team has proven to be an advantage for our clients.
  • We approach this environment with patience and diligence. Within our fixed income portfolios, our duration positioning has become more defensive in anticipation of more normalized levels of interest rates. Furthermore, a normalization of market risk has the potential to steepen the yield curve in concert with further rate cuts from the Fed. Within credit, we have maintained a relatively conservative posture, which has helped to mitigate downside risk during this correction. We continue to be selective in our credit exposure, avoiding issuers that we deem to be vulnerable to near-term downgrade pressures. In early February, we lowered equity sensitivities within our multi-asset class strategies, which allows us to be opportunistic in the case that conditions improve and/or attractive valuations present themselves.
  • For more information about specific Sage strategies, please reach out to your client service team at 512-327-5530.

 

 

 

* Source on all charts is Bloomberg.

 

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.

5 Key Themes That Will Drive Markets in 2020

Posted on by Sage Advisory

Sage’s base case going into 2020 is a market environment characterized by stabilizing growth, low inflation, and continued monetary and fiscal policy support. The following are five themes that will impact market performance in 2020.

To listen to Sage’s 2020 market outlook podcast and how we are positioned for the first half, click here.

 

1. The U.S. Consumer

The domestic household sector remains the engine of U.S. economic growth. Household debt service capabilities are the healthiest they’ve been in over 30 years, and the labor force continues to expand, with the unemployment rate continuing to fall to cycle lows.

 

Source: Sage, Bloomberg

 

2. The Trade War

2019 was a year of de-escalating trade tensions, culminating in a “phase one” trade deal between the U.S. and China. Easing of trade tensions was a contributing factor in the late-year rally. If the status quo holds, trade issues should remain in the background. A quiet period of trade rhetoric would dampen volatility and lift economic sentiment.

 

Source: Sage, Bloomberg, Reuters

 

3. Central Bank Accommodation

After years of balance sheet contraction due to tighter monetary policy, global central bank balance sheets expanded in 2019, as global central banks enacted easy money policies in the face of slowing economic growth. Central banks are not expected to change policy course in 2020, which should continue to provide support to financial assets.

 

Source: Council on Foreign Relations

 

4. Corporate Earnings

A recovery in economic activity coupled with low inflation will be required for strong corporate earnings growth. Although corporate profit margins are at a 30-year high, inflation could raise costs and negatively affect corporate profitability.

Source: Sage, Bloomberg

 

5. The Presidential Election

Over the past 90 years, equities and fixed income have typically fared well during presidential election years, with 19 of 23 election years resulting in positive equity returns and 21 of 23 years resulting in positive returns for U.S. Treasuries.

Source: Sage, Damodaran Online (NYU)

 

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.

Potential Winners of the SECURE Act (other than the American People)

Posted on by Sage Advisory

by Andy Poreda

Last week, the House passed the Setting Every Community Up for Retirement Enhancement (SECURE) Act of 2019. It was a clear win for the American People, many of whom are in desperate need of ways to enhance their dreary retirement savings prospects. The act will provide desperately needed changes to retirement legislation, an area that has been largely ignored since the Pension Protection Act of 2006 was signed into law. And although the American people stand to benefit immensely once the SECURE Act is signed into law by the President, so too do quite a few players within the $27 trillion retirement industry. Let us take a look at some of the groups that stand to gain the most from this act.

401(k) Providers

401(k) service providers just hit the jackpot with the SECURE Act. One of the key provisions of the act further facilitates the formation of open multi-employer retirement plans, allowing groups of small employers to band together to offer a common 401(k) plan. This pooling of unrelated employers (previous rules allowed for some related employer groups to band together) will ideally lead to lower fees and less fiduciary burden for small businesses. Consequently, employee access will also improve, and participants may receive a more robust set of investment options. Since somewhere between a third and a half of employers do not currently sponsor any type of retirement plan, 401(k) service providers will have tens of millions of potential new clients that may be more willing than ever to finally establish a plan.

With current all-in fees (includes administration, record-keeping, and financial advising) running upwards of 3% on some plans, the actual benefit of setting up a 401(k) is severely eroded. So expect providers to quickly respond with a push to capture the wide-open small business market with comprehensive plan management options offering low fees and basic financial advising as part of multi-employer group deals. Small businesses that are already sponsoring retirement plans but that are unhappy with their current fee structure will also be targets to change providers, as lower fees or better services may become available. Ultimately, a seismic shift is about to occur in the 401(k)-provider landscape over the next few years.

Insurance Companies

Some retirees view annuities with disdain, while others are fearful of the details, worrying about whether they made the right financial decision with their limited retirement savings.  Regardless of one’s perspective on annuities, it is undeniable that for many retirees a properly selected annuity could provide added utility to their portfolio, especially for those fearful they might outlive their savings. Since the Safe Harbor provisions of the SECURE Act shift most of the burden of annuity choices from the employers to the insurance companies, it is likely that many more employers will soon start offering more annuity options to their employees. The insurance companies will clearly look to capitalize on the enhanced access to millions more retirees in search of investment options.

A specific product to look out for is the Qualified Longevity Annuity Contract (QLAC), a deferred income annuity where payments can be delayed up to the age of 85. One big benefit of the QLAC is that a portion of one’s 401(k) (up to 25% or $130,000) can be used to purchase one, and it is exempt from required minimum distribution calculations, a factor to consider for some retirees. The other huge benefit is the significant increase in the monthly payout values that are a result of delaying payments until a much later date. As many retirees may have to deal with the distinct possibility that they live well into their late 90s, while also facing significant medical care costs, a QLAC could provide these individuals the peace of mind that they are not going to outlive their savings. When coupled with a traditional retirement account, one could drawdown from funds remaining in a traditional IRA, and once depleted the QLAC would kick in, in essence acting as an insurance policy against longer life expectancy. Currently many employers are reluctant to offer QLACs and annuities in general, but we predict that will soon change.

Insurance companies might also stand to gain from the elimination of the “IRA stretch” strategy. The “IRA stretch” was an effective estate planning tool that allowed for heirs of IRA plans to make minimal withdrawals, thereby allowing the account to continue to accrue tax-deferred benefits for years. The SECURE Act now forces withdrawals to be made fully within 10 years of an individual’s death, and it is possible that the timeline will be further compressed, as the Senate’s retirement act lowers the timeline to five years. Either way, the benefit of passing down IRAs to heirs will be diminished as a transfer-of-wealth option. Could this open up a shift to other investment choices, such as life insurance policies? Death benefits are not income-taxable, so purchasing a life insurance policy structured with a large death benefit may become a viable option for some investors seeking to transfer wealth. Obviously, it will take some time to fully analyze the ramifications of some of these provisions, but it is interesting to think about the impact on future estate planning.

Although the retirement industry aims to profit from the sweeping reform taking place in Washington, as we mentioned before, American workers are the true winners. Here at Sage, we are excited to see the new focus that politicians are placing on retirement issues. In a time where most issues have become heavily divisive, it is pleasant to see an area where there is so much agreement. Hopefully retirement reform will enjoy continued momentum, and more complex issues such as Social Security and automatic IRA enrollment will be addressed in the future. Any help the American People get on retirement is a plus. Sage and its team of professionals build dynamic liability and cash-flow-oriented investment strategies for pension and cash balance plans, in addition to providing asset allocation strategies for 401(k) plans. For more information, visit: https://www.sageadvisory.com/retirement-plans/

 

 

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.

China’s Conundrum: Why a Trade Deal Remains Out of Reach

Posted on by Sage Advisory

by Komson Silapachai

It was the winter of despair, it was the spring of hope, we had everything before us, we had nothing before us. Charles Dickens’ timeless words in the opening of A Tale of Two Cities serves as a poignant reminder of the fear and greed that dictate the movement of financial markets. The trade war was all but resolved; now the deal is effectively off the table.

We think the bar is high for the U.S. and China to strike a deal on structural issues, such as changing China’s laws on forced technology transfer and the protection of U.S. intellectual property. China’s economic development objectives are fundamentally at odds with U.S. interests. Our base case is a prolonged negotiation period with any agreed-upon deals centered around correcting the U.S./China trade imbalance rather than the structural issues around each country’s economic system. In this scenario, we see a prolonged period of uncertainty in which risks of shocks to global growth (especially in Asia), investor sentiment, and asset prices remain squarely on the downside.

To process the current U.S./China trade battle requires a broader look at the larger structural issues that have created the underlying causes of tension.

China’s Economic Development is the Antithesis to U.S. Interests

China’s rapid ascent to the world’s largest economy is attributed to its role as the preeminent low-cost manufacturer. However, China is currently facing the problem of a “middle income trap,” a stage in economic development in which a country loses its competitive edge as purely an exporter, and concurrently, is unable to keep pace with developed countries in the production of value-added goods, such as high technology. Avoiding this outcome is nothing short of an existential issue for such a large, highly-indebted, populous nation.

To transition to a developed economy, China is undertaking a historic transformation: from a low-wage manufacturer dependent on external demand to a high productivity, high technology, value-added producer with increased dependence on its domestic economy. “Made in China 2025,” a state-led industrial policy introduced in 2015, addresses the methods by which China aims to make this transition. According to James McBride and Andrew Chatzky at the Council on Foreign Relations, China’s methods include setting explicit targets, providing direct subsidies, acquiring foreign tech companies, mobilizing state-backed companies, and forced technology transfer.

Therein lies the “structural issues” inherent in a trade agreement – China’s objectives are at the United States’ expense. The U.S. stands to lose its competitive edge as the epicenter of technology and value-added goods; while on the other hand, China cannot afford to deviate from its transition to a developed economy due to the looming middle-income trap.

On May 3, Reuters reported that China sent a diplomatic cable in which it “had deleted its commitments to change laws to resolve core complaints . . . theft of U.S. intellectual property and trade secrets; forced technology transfers; competition policy; access to financial services; and currency manipulation.” At the eleventh hour, China couldn’t commit to abandoning its best hope for an economic transformation.

The U.S. subsequently raised tariffs on $200 billion of Chinese goods to 25% at 12:01am on Friday, May 10. The tariffs are expected to have a material adverse effect on the Chinese economy – Citigroup economists expect the effect of incremental tariffs to result in a -0.5% reduction in Chinese GDP and removal of 2.1 million jobs in China over the medium-term.

Market Implications

Here is our outlook regarding trade for the coming months. Our base case is a prolonged negotiation period stretching into 2020, which should result in a period of higher uncertainty in markets balanced with continued policy support from global central banks. Less probable cases include a near-term trade agreement that could take place in two forms: a correction of the U.S./China trade imbalance with less focus on structural issues (more probable), or a trade deal in which China agrees to change its laws around competition and intellectual property (less probable). The risk of a no-deal is not zero, but we believe it is less likely as it is mutually destructive, and both countries could continue to “kick the can” of negotiations further and further into the future. The table outlining our outlook is below.

 

 

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.

 

Five Questions to Ask your Municipal Bond Manager

Posted on by Sage Advisory

by Jeffrey Timlin

  1. At current valuations, should I wait to invest cash in the municipal market?

All things being equal, history has shown that bonds outperform cash over most time periods. Although municipal valuations are not super attractive right now, every asset class is rich and trading at or near their all-time highs. The benefit of municipal bonds is not only tax-free income, but as an asset class, it is negatively correlated to the broad market during market downturns. If equities enter a corrective phase, municipal bonds typically hold up well and may even experience modest price appreciation.

 

  1. When will the strong technical environment normalize?

To be sure, the record municipal cash inflows experienced year-to-date cannot last forever. The caveat to that remains the ongoing reduction in new issue supply, as well as the elevated levels of maturity and coupon payments coming due. Historically, periods of significant outflows have coincided with negative returns as investors and funds alike were forced to liquidate positions to raise cash. Unlike those periods, the current environment shows mutual funds sitting on higher levels of cash and they are cushioned by higher levels of maturity and coupon roll-off. Lastly, as a result of the decade-long recovery, a record number of millionaires now reside in the U.S. – more than 11 million people. These millionaires benefit fully from the tax-exempt income offered by municipal bonds, especially the ones who live in high-tax states.

 

  1. Are there any credit issues that I should be concerned with?

Overall, there are no serious credit concerns within the municipal market. Several well-known credits, such as the State of Illinois, City of Chicago, and Puerto Rico remain challenged and should be reviewed on a quarterly basis. Although mid-to-long-term issues do exist regarding pension and health care funding levels, there is not cause for immediate concern. Due to the monopolistic characteristics and taxation powers inherent in most municipal issuers, the municipal market remains one of the safest areas within the fixed income markets.

 

  1. I am worried about losing money in fixed income. What can I do to protect myself?

Many investors overestimate the downside risk of municipal bonds. Over the past 15 years, a core municipal strategy that has an effective duration of approximately six years and invests in maturities out to 30 years only had two negative-return years: 2008 (-2.49%) and 2013 (-2.55%). Even on a quarterly basis, the worst return during that time was -4.17% in the fourth quarter of 2010, after Meredith Whitney’s bogus municipal default prediction. To put that into perspective, the worst quarterly return for municipal bonds has occurred to daily returns in the equity markets on a fairly consistent basis. For investors looking to minimize downside risk, municipal strategies with a duration of four years or less tend to offer an attractive yield, while limiting principal loss on a yearly basis.

 

  1. Why does it take a few weeks to get my portfolio fully invested?

Municipal portfolio cash could be invested in a day or two, provided the investor is not concerned with valuations or optimizing their sector and credit profile. Unlike equities, which are constantly available, municipal bond supply ebbs and flows daily. A bond that trades today may never trade again if held by buy-and-hold investors. In addition, Sage is a value-based investor that screens the market for attractive offerings. A combination of new issue, secondary offerings, and bid wanted are utilized to source bonds at attractive levels. Each of these avenues opens and closes daily and takes time to access. Sage believes that having the patience to wait a few weeks to purchase the most attractive offering will pay dividends in the long run.

 

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.

Auto Loan Losses: Navigating Through the Noise

Posted on by Sage Advisory

by Seth Henry

Over the last few quarters, there have been numerous news headlines noting the rise in auto loan delinquencies. The headlines tell only part of the story, however, as many of the losses can be attributed to subprime auto loans, which comprise roughly 40% of the auto loan market.

Over the past decade, losses on automobile asset-backed securities (ABS) had actually trended downward and reached historic lows. This is due in part to the strong financial position of the American consumer. A decade of historically low rates combined with very low unemployment helped to keep the consumer in a stable environment and auto loan defaults relatively low. While it is true that delinquencies and losses have increased, this is due primarily to losses in the subprime portion of the auto loan market, which is $55 billion of the $140 billion market. Specifically, delinquencies and losses have increased for subprime issuers who have a poor track record for underwriting and managing risk.

While current losses on prime auto loans are higher than their historical lows (0.56% vs 0.30%), they are still very low and well within expectations.

 

Over the last five years, smaller-scale (non-benchmark) subprime issuers have seen losses increase from 7.60% to 9.90%, a much larger increase that weighs on the sector as a whole.

 

 

Despite subprime auto weakness, Sage believes that prime auto borrowers are in a healthy position and do not pose a systemic risk. Given the strong job market, consumer ABS is still a healthy sector with a compelling risk-reward value. The sector is largely AAA-rated, and a great alternative to other high-quality, lower-yielding assets.

 

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.

Notes from the Desk: Is Now the Time to Extend Duration?

Posted on by Sage Advisory

by Robert Williams

Cash and ultra-short fixed income investors continue to enjoy the fruits of nine Fed rate hikes. Yields on cash hover around 3% with relatively low interest rate sensitivity. However, with the Fed done raising rates, core yields now 60 basis points lower than six months ago, and the economy in the later part of the cycle, bond investors who tactically shifted to cash and ultra-short allocations should start to think about whether or when to extend out the curve. The decision to extend duration to a short or intermediate duration strategy depends largely on an investor’s expectation for the yield curve.

What is curve telling us and where does it go from here?

The yield curve has flattened to near zero, as it typically does during a Fed tightening cycle, usually as a precursor to an inversion and a recession. With the Fed signaling no further hikes and the U.S. still experiencing decent grow, curve inversion in the near-term appears unlikely. In fact, markets are now pricing in a probability, albeit low, of an interest rate cut as early as the end of 2019. Where we go from here requires an outlook call on growth and inflation. Below we outline our outlook in three scenarios, including their likely impacts on the curve.

 

Outlook Scenarios (Next 6-12 Months)

 

Base Case and Recession Expectations

Our base case is for low, but stable growth in the U.S.; a modest uptick in inflation, which keeps the curve flat; and a modest steepening bias possible. We see the greater risk of this backdrop eventually transitioning to weakness, rather than above trend growth, and expect the next directional move in the curve to be a steepening bias as the Fed cuts rates. This part of the scenario looks further down the road, as the curve and data suggest near-term recession odds remain low. While portions of the curve briefly inverted in March, it didn’t last more than a couple days and regardless, the lag time between curve inversion and recession or even market peaks are typically several quarters. Recent data trends in the U.S. have been improving, which has been putting more slope back in the curve, but not so strong as to put the Fed hikes back on the table and cause a flattening/inversion trend to resume.

 

 

Extending and Historical Returns

Given our outlook, the idea of at least beginning to consider a strategy extension makes sense given the higher probability of a flat-to-modest steepening environment and a more limited chance of near-term inversion or meaningfully higher long rates. We also looked at past curve environments to understand return differences historically when moving out in duration. We used the last four curve inversions referenced in the table below as a basis.

 

 

For each period, we calculated returns across cash, short gov/credit, and intermediate gov/credit across three periods:

  • Flattening: 6 months leading up to the inversion
  • Flat/Inverted: the inversion period
  • Steepening: 6 months after the end of the inversion period

The results illustrated below also support the idea that cash makes sense in periods when the yield curve is flattening during a tightening cycle, but that post-cycle it has made sense to move out on the curve.

 

 

Given our current outlook, likely curve scenarios, and historical returns data, cash and ultra-short strategies still makes sense, but investors should start considering at least a push out to short strategies. Further, as the curve continues to steepen near-term, the risk/reward will become increasingly favorable for extending to an intermediate duration strategy.

 

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.