Is a U.S. Recession Coming? Does it Matter?
There has been a frenzy on Wall Street and in Washington to embrace a "recession is coming" position. Wall Street economists are shifting their forecast to one of recession, the federal government has streamlined efforts to cobble an anti-recession stimulus package, and various Federal Reserve "hawks" have shifted their position, finally acknowledging downside risks to the economy.
February 12, 2008
Engineering LDI: Circumspect Pension Planning
When a pension plan practices liability-driven investing, it matches the risks of plan assets to those of plan liabilities. The plan recognises that its true risks arise from movements in assets relative to liabilities, and so it manages the risks of its funded balance (assets minus liabilities), not merely of its assets alone. This same level of perspective should be applied at both the macro and micro levels of plan management. At the macro level, the corporate plan sponsor should recognise pension plan assets and liabilities as part of corporate assets and liabilities, and pension plan management should be integrated into corporate financial management. At the micro level, asset allocation tactics should be coordinated within an aggregate plan strategy. The plan's decision on how much interest rate risk to tolerate should be in balance with its decisions on how much equity market and spread risk to tolerate and these decisions should be consistent with the real-world precision of the financial instruments available to the plan.
May 5, 2008
U.S. Economic Update - Is it Inflation?
Is the U.S. experiencing rising inflation? No, it's not. (No beating around the bush.) Yes, the media constantly run features such as "Inflation Nation," and yes, even the Fed is concerned that consumers and business are forming expectations of continued, elevated inflation. Yes, there are real problems in the energy markets, and there appear to be emerging problems in agricultural markets. But this is not inflation.
July 11, 2008
Housing Crash Experience: Japan versus the U.S.
In a recent white paper, we argued that establishing a bottom in U.S. homebuilding would provide a boost to economic growth. That boost would dramatically reduce—or eliminate—the chances of a U.S. recession. Recent evidence suggests that such a bottom is forming. In addition, the data indicate that declines in U.S. home prices are moderating, possibly even disappearing, and these signs give hope that the subprime mortgage crisis could be coming to an end.
September 23, 2008
Turbulent Times but Economic Convergence Continues
Until September, emerging market bonds had largely avoided the heavy selling pressure that afflicted other risky asset classes during the past year and a half. U.S. dollar-denominated debt had sustained only a gentle repricing, and currencies strengthened relative to the U.S. dollar. U.S. and European banking supervisors had even hoped that emerging markets sovereign-wealth funds would help recapitalize their beleaguered banking systems.
November 13, 2008
Credit Default Swaps
In a market that is characterized by unprecedented volatility, Western believes that credit default swaps, including single name issuer contracts (CDS) and index contracts (CDX), represent an effective tool for managing exposure to corporate risk quickly, at a low cost and, in the case of the CDX contract, with significant diversification. The size of the market relative to the size of the cash market also contributes to the importance of these instruments. Given the market's concern regarding these instruments, we continue to keep close watch on regulatory initiatives coming from within the industry and from Washington. Lastly, Western Asset is committed to providing transparency and communication on this and other complex issues in these extraordinary times.
November 4, 2008
What is the Fed Doing?
In the last three months, the Federal Reserve (the Fed) has drastically changed the way it conducts policy. For nearly two decades, the Fed had accounted its policy strictly in terms of interest rates, more specifically in terms of Fed funds and Treasury rates. Since September, it has begun to pay explicit attention to "quantitative" measures of money in the financial system, in the process engineering a dramatic expansion of the money stock. The Fed has also tacitly acknowledged that whatever the level of Treasury yields, private-sector borrowing rates are also (more?) important in influencing economic activity, and it is considering ways to directly influence private-sector rates.
December 30, 2008
Money Markets: The Centre of the Storm
Money markets have been at the centre of the storm from the beginning. They were the first sector to be seriously disrupted when financial strains surfaced eighteen months ago. They have caused the most collateral damage, not only to the wider financial system but to the entire global economy. Normalcy will not be restored until these markets are again functioning properly. Encouragingly, they have shown tremendous improvement in the past few months.
January 22, 2009
Credit: An Historic Opportunity
The past two years have comprised the worst period on record for the investment-grade credit market in terms of relative return versus U.S. Treasuries. The asset class generated 2,442 basis points (bps) of negative excess return for the two-year period ending January 22, 2009, a beating well beyond anything it had seen before. We believe that the massive sell-off of investment-grade corporate bonds has gone too far and that the asset class offers an attractive investment opportunity at current, historically wide spreads.
February 4, 2009
An Overview of 2009 U.S. Fiscal Policy Actions
In the first seven weeks of the new Obama administration, a fiscal stimulus package has been passed and a far-reaching budget reform bill is waiting in the wings. Attention has naturally focused on how these initiatives will impact the economy, and an overview of the likely effects is presented here.
March 17, 2009
Is It Time to Rebalance?
With the broad stock market down nearly 50% since December 2007, some institutional investors are considering rebalancing their portfolios, shifting fixed-income allocations to equities to re-attain the equity exposure they would normally target (that exposure having declined because of the drop in equity valuations). We believe such a response is much less appropriate now than might have been the case after past sell-offs.
April 8, 2009
TALF, PPIP and Fed Policy: Why the Fed's Balance Sheet Didn't Expand Until September
Recently, the question has arisen as to how the Term Asset-Backed Securities Loan Facility (TALF) and Public-Private Investment Program (PPIP) facilities will affect the balance sheet of the Federal Reserve (Fed). Answering this question is useful not just for its own sake, but also for providing perspective on the Fed's activities since September 2008. In this white paper, we first explain the Fed's balance sheet and then relate this issue both to Fed policy setting in general and, more specifically, to the Fed's actions so far this year.
May 5, 2009
Active Equity and Passive Bonds?
Some analysts currently recommend that institutions move to passive-only exposure in fixed-income while maintaining active management in equities. In order for such tactics to be advisable, an investor should have a firm conviction that positive active returns—or alpha—can be reliably obtained in equities and only in equities. Evidence supporting that conviction would be a finding that information ratios for equity managers thoroughly dominate those for fixed-income managers.
June 4, 2009
Fed Exit Strategies: Are They Needed? What Would They Look Like?
In the months following the financial system's near meltdown in September 2008, the Federal Reserve (Fed) injected massive amounts of liquidity into the financial system to lower private-sector borrowing rates, stimulate growth in the money stock and generally assuage stress on the economic system. In the wake of these operations, speculations abound about whether and how the Fed will be able to reverse the monetary stimulus without generating rising U.S. inflation and without disrupting financial markets.
August 6, 2009
Is The Consumer Key to U.S. Recovery?
The view among most of the Wall Street crowd is that the pace of consumer spending will be the critical factor determining the strength of U.S. economic recovery in the next few years. Their story is that the consumer has been the linchpin of all postwar recoveries, the current recession was consumer-led, and U.S. consumers will therefore need to lead the economy into recovery. The catch is that with consumers in deleveraging mode, the Street fears that growth in consumption and GDP will remain sluggish for the foreseeable future.
August 24, 2009
The Resurgence of Chinese Economic Growth
The Chinese economy has undergone a V-shaped rebound in its growth trajectory in 2009. The latest GDP release for 2Q09 shows a sharp rebound expanding 7.9% year-on-year (YoY) compared to 6.1% in 1Q09. The Chinese government's timely and aggressive stimulus policies put in place last year have been instrumental in reviving the economy. To recap, the government implemented a massive RMB4 trillion fiscal stimulus package late last year while the reserve requirement ratio and lending rates were slashed a respective 200 and 220 basis points (bps) in the aftermath of the Lehman Brothers collapse.
September 11, 2009
Inflation-linked Debt: Shock Absorbers for the Bumpy Road Ahead
We believe that inflation volatility should remain well above levels established during the past 25 years, a period admiringly described as the Great Moderation. This is not a one-off threat stemming from quantitative easing or the current financial crisis. We believe inflation volatility will likely be a continuous concern over the next business cycle and beyond. Given this increased uncertainty, the need for inflation insurance is greater than ever.
October 5, 2009
Emerging Asia and The Safety Of Creditor Economies
Global imbalances-large trade deficits in advanced economies offset by large trade surpluses in emerging economies-dominated policy discussions until early 2007, when the immediate threat of global financial collapse displaced this massive medium-term challenge. Today, after lying dormant for two years, the debate is reviving and appears to be more consequential than ever: there are compelling arguments that global imbalances contributed to the financial crisis.
December 17, 2009
Active Equity and Passive Bonds? Revisited
Some commentators are recommending that investors restrict fixed-income allocations to passive mandates, confining active management to equities or alternatives. In a 2009 white paper, "Active Equity and Passive Bonds?", we pointed out that in order for such an approach to be advisable, information ratios for active equity managers should thoroughly dominate those for active fixed-income. We found that actual results did not support this. If anything, active fixed-income information ratios were superior to active equities.
9 March, 2010
Emerging Market Debt: Think Local, Trade Global
Emerging-market debt has outperformed many major asset classes on a risk-adjusted basis over the past 15 years (Exhibit 1). As illustrated by the historical Sharpe Ratios in Exhibit 1, hard currency sovereign debt (represented by the Emerging Markets Bond Index Global, or EMBI Global, and the Emerging Markets Bond Index Plus, or EMBI+), hard currency corporate debt (represented by the Corporate Emerging Markets Bond Index Broad, or CEMBI Broad) and local market debt (represented by the GBI-EM Global Diversified) all look favorable relative to the performance of high-yield debt, stocks (represented by the S&P 500) and US Treasuries.
March 25, 2010
Stagnation Is Not Normal
The current consensus forecast for the US economy is for growth to proceed indefinitely at a rate of 2-3%, a rate equal to currently accepted estimates of long-run potential (trend) growth going forward. If the economy were at or reasonably near to full-employment, trend growth would make sense. However, the economy is nowhere near full-employment; it is more depressed than at any time since the Great Depression. From such a depressed state, 2-3% growth would be, in effect, a "no-recovery" recovery.
May 4, 2010
The Real Message of LDI
By now, liability-driven investing (LDI) has become a household name among defined-benefit pension (DB) plans worldwide. Major DB global accounting and regulatory reforms occurred some years ago, making DB plans more acutely aware of the short-term volatility in their funded balance, and we have since seen a proliferation of DB efforts to engage in various LDI tactics such as liability matching, dollar-duration matching, swap overlays and more.
May 27, 2010
China's Exchange-Rate Regime
While details remain thin, it seems likely that China will re-introduce the crawling peg that existed from July 2005 until July 2008, at which time a parity of 6.83/USD was fixed. During the following three years of managed flexibility, the yuan gained 21% against the US dollar (it lost 8% against the euro). Appreciation expectations are more modest today. Non-deliverable forward (NDF) contracts imply an appreciation of around 3% over the next 12 months against the dollar, up from near 0% a month ago but still below the expectations seen earlier in the year. More bullish forecasters call for closer to 5% appreciation in the next year.
July 14, 2010
A Global Safe Asset Shortage
The location of the 2007-2009 financial crisis is more remarkable than its magnitude. Financial crises of similar magnitude are inherent to the development process "as countries struggle to transform themselves from emerging markets to advanced economies." However, the current crisis erupted in advanced economies, not emerging markets, and had nothing to do with a struggle along the development spectrum. Domestic failings were undeniably involved in the run-up to the worst crisis to afflict advanced economies in 75 years.
July 14, 2010
Emerging Markets: Revisiting the Investment Thesis in an Era of Debt
The landscape of the global sovereign debt market has changed drastically since the problems in Greece first arose earlier this year. Markets have been incredibly resilient in the face of
these issues, with the effectiveness of Europe's response to the crisis far exceeding what were fairly dire expectations. However, it was the emergence of these problems at the sovereign level that served to highlight a number of risks that had, to that point, been underestimated-from the presumption of currency union infallibility to the stability of a banking system with substantial holdings of sovereign debt no longer considered to be risk-free.
September 21, 2010
Is the Soft Patch For Real?
There is near universal consensus among Wall Street analysts and Washington policy-makers that the US experienced a significant slowing in economic growth in recent months, a phenomenon commonly referred to as a soft patch. No less prominent an observer than Fed Chairman Ben Bernanke has stated publicly and flatly that the pace of growth has slowed and that the Fed is contemplating further stimulus.
27 September, 2010
Principles of Investment Risk Management
The credit crisis that began in 2007 reminded us of some lessons about risk management that we may have forgotten, but it didn't show that fundamental principles have to be rethought. In fact, the credit crisis emphasized the importance of those very same principles, three of which we believe to applicable always and everywhere: prediction is very difficult, especially if it's about the future; investing is not a game, and clarity is imperative.
October 4, 2010
Foreclosure Moratoria in the News
There have been a multitude of news stories over the past few weeks discussing foreclosure moratoria actions taken by several banks in various states across the country. While the news media
seems particularly focused on the "robo-signer" issue, other issues relating to the foreclosure process have been raised and continue to draw attention to loan servicing processes. Western
Asset's non-agency mortgage team is constantly monitoring how the nuances of mortgage servicing impact both the mortgage market as a whole, as well as the long-term value of our securities.
October 25, 2010
Emerging Markets: Navigating the Rising Tide of Global Liquidity
Capital is pouring into emerging markets. For those who remember the "boom and bust" cycles of the 1980s and 1990s, this is nothing new. However, the catalysts that fostered the gradual build-up and rapid reversal of foreign capital inflows during those periods are markedly different from those driving the wave of liquidity towards emerging markets today.
October 29, 2010
Can Interest Rates Decline from Historic Lows?
Low government interest rates do not necessarily imply inflationary monetary conditions; indeed, a low nominal interest rate may be a sign of expected disinflation and restrictive monetary conditions. With this in mind, recall that the last time interest rates were as low as they are today was during the 1930s and 1940s. That phase was characterised by the aftermath of the Great Depression and the misguided constraints of a disintegrating gold standard.
November 3, 2010
The Fed's Adventures with QE2: Muddying the Waters
After a month-long campaign of preparing the financial markets, the Federal Reserve (Fed) has moved forward with plans to attempt to further stimulate the economy through additional asset purchases, known as Quantitative Easing Part II, or QE2. It will expand its balance sheet by $600 billion over the next eight months. The Fed has defined its schedule of purchases across maturities fairly precisely, and most purchases will occur within the maturity range of two to 10 years.
November 24, 2010
What the Fed is Actually Doing
The fear of rising interest rates seems ubiquitous these days. One driver of this fear is the belief that US inflation is set to take off, thanks to the US Federal Reserve's (Fed) second round of quantitative easing (QE2). But there is quite a gap been perception and reality concerning the Fed's QE2 policy.
2 February, 2011
Currency Considerations: Investing Through the Distortions
Motivated by a combination of heavy government debt issuance and aggressive monetary accommodation, investors in the US, Europe and Japan are becoming more interested in the merits of overseas diversification. Certainly, most investors are severely underinvested in markets outside of their home countries. This so-called "home bias" has been measured extensively, and its size has long been a puzzle. Unfamiliarity with international markets is cited as the chief explanation of the seemingly irrational decision to concentrate assets based on geographic proximity.
February 17, 2011
Emerging Market Corporate Bonds: Leading the Charge
Issuance of U.S. dollar-denominated bonds by corporations headquartered in the emerging world began to rapidly increase six years ago. Emerging market governments began to balance their budgets, let their currencies float more freely, significantly reduced their external debt, and became large global net creditors. As the supply of external sovereign debt declined significantly, these economies experienced a significant increase in GDP growth as a result. Moreover, as many governments began to aggressively retire their external sovereign debt by redirecting financing towards budding local currency markets (please see our paper entitled "Emerging Market Debt: It's Not Just the EMBI Anymore!"), the crowding-out of corporations by their respective governments in the external markets was significantly reduced. The void created by the absence of sovereign issuance was quickly filled by corporations with significant capacity constraints but limited local financing opportunities.
April 22, 2008
A New Year's Investing Resolution: Get Active...
As we embark on a new investing year, we are hearing concerns from investors regarding their fixed-income allocations. Conventional wisdom is: a) reduce duration, as interest rates are likely to rise, and b) increase liquidity to protect against systemic risk. While we are not convinced that rates will move significantly higher in 2011, we do acknowledge that it is a risk. The chances of another systemic event are also real and are worthy of consideration. So what should an investor do? One thing we can recommend with confidence is that investors continue with active management.
January 26, 2011
The Interaction of Investment and Capital Management for Insurers
Insurance industry regulation and financial reporting are undergoing significant reform. For example, the upcoming European Solvency II regulatory regime embraces a market-consistent approach to the valuation of an insurance company's balance sheet and capital position. Capital requirements are calibrated based on economic risk; this brings transparency to the market-consistent value of insurance companies' capital positions and risk exposures.
March 2, 2011
Emerging Markets at Western Asset
Emerging markets (EM) have been attracting more investor attention and money flows recently. But investing in this asset class is not a new trend at Western Asset. Emerging markets have been a part of our US Core Full Discretion product since 1993. In this Q&A, Portfolio Manager Matthew Duda talks about emerging markets at Western Asset and discusses opportunities in the emerging market corporate asset class.
16 March, 2011
Mortgage-Backed Security Fails
Much has changed since messengers on bicycles physically delivered Government National Mortgage Association (GNMA) certificates around lower Manhattan on GNMA delivery day.
The settlement of mortgage-backed securities (MBS) is now almost completely electronic, yet current market conditions have recently resulted in increased MBS trade settlement failures, or
"fails." It is important to understand how and why an MBS fail occurs and what costs it poses to investors.
20 December, 2010
A Note on the Japanese Catastrophe
Japan was struck by the largest earthquake in its recorded history, followed by a tsunami that exacted a devastating human toll. To compound matters, the tsunami knocked out the backup
cooling systems at the Fukushima Daiichi nuclear power plant, leading to explosions in multiple reactor units and radiation exposure for tens of thousands living in the area. The potential
fallout from the nuclear incident is highly uncertain and continues to drive market pricing.
18 March, 2011
The US Recovery in Year 2
The US economy has been in recovery for over 18 months, with GDP growth averaging about 3% over that period. While that pace exceeds what most forecasts were looking for two years ago, disappointment with the pace of recovery is rampant, and that is understandable given the fact that unemployment rates are still very high. This paper attempts to reconcile the facts and the sentiment. We analyze where the recovery has been satisfactory, where it has been deficient,
and where stronger growth is most likely to emanate from, if the recovery is to attain the 4%-5% growth pace that would be required (temporarily) to bring unemployment back down to acceptable levels within an acceptable time frame.
March 25, 2011
Insuring Against Systemic Risk for Defined Benefit Plans
Many defined benefit pension plans have expressed concerns about the prospects of rising interest rates and the impact on their fixed-income assets. This white paper proposes that perhaps the environment that many defined benefit plans should be concerned with is not that of rising yields but that in which yields precipitously fall due to a systemic shock. The typical defined benefit plan's funded status has already experienced negative volatility from this very scenario a few times just in the past decade. To protect against this scenario, plans can buy insurance against the negative impact of falling yields by, in effect, purchasing a call on rates (so that the value of the option rises as rates fall). This allows the plan to benefit from additional duration should rates head lower.
April 13, 2011
GMS: Local Access to the Global Market
Access to the global markets is of ever-increasing importance. Some investors may be looking to draw on a mix of sectors and asset classes within their own borders while also diversifying globally. Western Asset Management Company's Global Multi-Sector (GMS) strategy is intended to enable just that. For over 15 years, this strategy has provided access to the global fixed-income universe and has aimed to reduce overall volatility by combining investment-grade corporate and government bonds with high-yield and emerging markets.
4 May, 2011
Derisking Your Pension Plan, Part 1: PBO or ABO Funding Target?
It is well known that long-duration bonds are the low-risk asset for defined benefit (DB) pension plans. By increasing allocations to fixed-income and extending duration on those assets, plans
can reduce the volatility of their funded balance. This paper is the first in a series dealing with the endgame of such efforts, the issues a DB plan faces when it attempts to reduce risk to an
absolute minimum.
6 May, 2011
Europe in the Balance
Despite a clear trend toward greater exchange-rate flexibility during the second half of the 20th century, the countries of Western Europe chose to go against the global consensus, forming the largest network of fixed exchange rates since the gold standard. Seventeen countries with a combined population of more than 325 million have fixed their exchange rates to one another using the most durable - some say irreversible - means possible: adopting a common currency managed by a single central bank.
25 May, 2011
Take Cover: The Dynamics of Covered Bonds
The first quarter of 2011 saw record rates of covered bond (CB) issuance. Outstanding euro-denominated CBs (based on the Bank of America Merrill Lynch EMU Broad Market Index) totaled more than €900 billion at quarter-end. We are following this market closely, looking for investment opportunities in the sector and assessing its impact on other areas of bank capital structures.
21 June, 2011
Introduction to High-Yield Bond Covenants
In our January 2011 US High-Yield Investment Report, we wrote, "We believe that high-yield managers will differentiate themselves during 2011 through issuer selection." We expected that volatility would decline, performance disparities between rating and industry categories would be fairly muted, and issue selection would be the driving force that differentiated manager performance. Year-to-date (YTD) through June 6, 2011, the difference in total return among rating categories is down 39% and the difference in total return between industries is down 72%. Meanwhile, the difference in total return between the best and worst issuers is over 8,600 basis points (bps). These are market conditions in which investment management firms with strong credit teams can separate themselves from the pack.
28 June, 2011
Will the US Government Default on Its Debt?
There has been substantial coverage of the possible default of US Treasuries (UST) in the media and by Wall Street analysts. This discussion is driven by the need for politicians to raise the limit on issuance of US federal debt (e.g., UST). In 1917, the US Congress created a law that gave it the authority to set a limit on the amount the US government can legally borrow. The debt limit is the total amount of money that the US government is authorized to borrow to meet its existing legal obligations, including Social Security and Medicare benefits, military salaries, interest on the national debt, tax refunds and other payments.
July 13, 2011
How Would a US Downgrade Impact Emerging Markets?
Moody's warning on Wednesday, July 13, that the US might lose its AAA rating as a result of the debt ceiling issue has prompted some questions regarding the impact of such a development on emerging markets. We believe that this "noise" has been with us for quite some time. Moreover, major structural problems exist not only in the US, but elsewhere in the developed world; these problems are widely known and reflect serious global imbalances that are challenging countries on the economic offensive and defensive fronts.
27 July, 2011
Contagion Risk From Europe's Crisis
In what seemed like a replay of the dynamic that ultimately forced Greece, Ireland and Portugal out of private capital markets, investors began pushing yields on Spanish and Italian debt toward unsustainably high levels beginning in mid-June. Reacting to rumours that he could be forced out of the government, Italy's finance minister, Giulio Tremonti, declared, "If I fall, then Italy falls. If Italy falls, so falls the euro." While the first link in his chain of causation is suspect, the last is not. Spain and Italy are both too big to fail yet too big to rescue, and Europe's monetary union would not survive a disorderly default by either nation. Once again, the global economy seemed perilously close to the edge of the precipice.
Short-Dated High-Yield Strategy
In a low-rate environment, more high-yield companies are looking to refinance their bonds to a lower coupon level. How can an investor potentially profit from this trend? Western Asset's Short-Dated High-Yield strategy targets bonds that are more likely to be tendered before their first call date - at a premium. Using bottom-up quantitative and qualitative analyses, Western Asset has identified short-duration high-yield bonds (typically with call protection expiring in the next two years) that are more likely to be called early.
August 22, 2011
UCITS IV Risk Requirements: The VaR Approach
The European Union recently approved new regulation on mutual funds called UCITS IV (Undertakings for Collective Investment in Transferable Securities, fourth edition). UCITS IV, which is patterned on regulatory risk requirements for banks, provides two approaches to regulatory risk management of a fund's portfolio: the Commitment Approach and the Value-at-Risk (VaR) Approach.
August 25, 2011
Emerging Markets: Braced for the New World Order
In this Q&A, Senior Research Analyst Robert Abad describes recent developments in the emerging market space, the risks that investors need to be aware of, and why Western Asset is well positioned to benefit from the changing dynamics within this market. In contrast to previous periods, external factors are increasingly driving risks within emerging markets. However, emerging markets have demonstrated an ability to weather broad market shocks, such as those that occurred in 2008.
September 2, 2011
Why Recent US Policy Stimuli Have Failed
Our outlook for the US economy is that growth will continue to muddle along, neither accelerating to a boom nor deteriorating to a double-dip recession. One reason we are not as negative as most Wall Street analysts are presently is that we don't believe that there will be significant drag on the economy from either the ending of the US Federal Reserve's (Fed) second round of quantitative easing (QE2) or from the expiration of various fiscal stimuli. We believe the end of these programs will fail to exert any substantive drag on the economy because they failed to substantively stimulate the economy when they were imposed. There are sound economic reasons to assert that recent monetary and fiscal stimuli did not have any actual stimulative effect.
October 13, 2011
Why Asia Matters: When East Meets West
The term "Shangri-La" never fails to evoke imagery of Oriental mysticism. Originating from English author James Hilton's 1933 novel Lost Horizon, Shangri-La was the fi ctional Tibetan
monastery bearing utopia-like qualities, where four Westerners sought refuge after a plane crash-landing. While geographically isolated and immune to the sociopolitical turbulence then
prevailing in the outside world, Shangri-La nevertheless drew heavily, in a material sense, from the world around it. Within its grounds were contemporary features, including central heating
and a grand piano, as well as bathtubs from Akron, Ohio.
October 24, 2011
EM Versus DM: EM's Dollar Liquidity Cushion and the Implications for Global Fixed-Income Investors
At the sovereign level in the developed world, market action over the last few years has been dominated by growing concerns about liquidity and solvency risk, which have been partially validated by numerous developed-country sovereign credit-rating downgrades and progressively weaker headline economic data over the last 18 months.
December 6, 2011
Total Return Unconstrained (TRU) Bond
In a new Q&A, Western Asset CIO Stephen Walsh discusses Western Asset's Total Return Unconstrained (TRU) Bond strategy. Formerly called Absolute Return, TRU Bond seeks to maximize returns by using the broadest cross-section of Western Asset strategies.
20 December, 2011
Fixed-Income Portfolio Benchmarks: Time for Re-evaluation?
There are good reasons to question whether traditional bond indices are meeting their primary objectives as benchmarks in bond portfolio management. This white paper presents some alternative approaches to benchmarking fixed-income portfolios.
There has been a frenzy on Wall Street and in Washington to embrace a "recession is coming" position. Wall Street economists are shifting their forecast to one of recession, the federal government has streamlined efforts to cobble an anti-recession stimulus package, and various Federal Reserve "hawks" have shifted their position, finally acknowledging downside risks to the economy.
When a pension plan practices liability-driven investing, it matches the risks of plan assets to those of plan liabilities. The plan recognises that its true risks arise from movements in assets relative to liabilities, and so it manages the risks of its funded balance (assets minus liabilities), not merely of its assets alone. This same level of perspective should be applied at both the macro and micro levels of plan management. At the macro level, the corporate plan sponsor should recognise pension plan assets and liabilities as part of corporate assets and liabilities, and pension plan management should be integrated into corporate financial management. At the micro level, asset allocation tactics should be coordinated within an aggregate plan strategy. The plan's decision on how much interest rate risk to tolerate should be in balance with its decisions on how much equity market and spread risk to tolerate and these decisions should be consistent with the real-world precision of the financial instruments available to the plan.
Is the U.S. experiencing rising inflation? No, it's not. (No beating around the bush.) Yes, the media constantly run features such as "Inflation Nation," and yes, even the Fed is concerned that consumers and business are forming expectations of continued, elevated inflation. Yes, there are real problems in the energy markets, and there appear to be emerging problems in agricultural markets. But this is not inflation.
In a recent white paper, we argued that establishing a bottom in U.S. homebuilding would provide a boost to economic growth. That boost would dramatically reduce—or eliminate—the chances of a U.S. recession. Recent evidence suggests that such a bottom is forming. In addition, the data indicate that declines in U.S. home prices are moderating, possibly even disappearing, and these signs give hope that the subprime mortgage crisis could be coming to an end.
Until September, emerging market bonds had largely avoided the heavy selling pressure that afflicted other risky asset classes during the past year and a half. U.S. dollar-denominated debt had sustained only a gentle repricing, and currencies strengthened relative to the U.S. dollar. U.S. and European banking supervisors had even hoped that emerging markets sovereign-wealth funds would help recapitalize their beleaguered banking systems.
In a market that is characterized by unprecedented volatility, Western believes that credit default swaps, including single name issuer contracts (CDS) and index contracts (CDX), represent an effective tool for managing exposure to corporate risk quickly, at a low cost and, in the case of the CDX contract, with significant diversification. The size of the market relative to the size of the cash market also contributes to the importance of these instruments. Given the market's concern regarding these instruments, we continue to keep close watch on regulatory initiatives coming from within the industry and from Washington. Lastly, Western Asset is committed to providing transparency and communication on this and other complex issues in these extraordinary times.
In the last three months, the Federal Reserve (the Fed) has drastically changed the way it conducts policy. For nearly two decades, the Fed had accounted its policy strictly in terms of interest rates, more specifically in terms of Fed funds and Treasury rates. Since September, it has begun to pay explicit attention to "quantitative" measures of money in the financial system, in the process engineering a dramatic expansion of the money stock. The Fed has also tacitly acknowledged that whatever the level of Treasury yields, private-sector borrowing rates are also (more?) important in influencing economic activity, and it is considering ways to directly influence private-sector rates.
Money markets have been at the centre of the storm from the beginning. They were the first sector to be seriously disrupted when financial strains surfaced eighteen months ago. They have caused the most collateral damage, not only to the wider financial system but to the entire global economy. Normalcy will not be restored until these markets are again functioning properly. Encouragingly, they have shown tremendous improvement in the past few months.
The past two years have comprised the worst period on record for the investment-grade credit market in terms of relative return versus U.S. Treasuries. The asset class generated 2,442 basis points (bps) of negative excess return for the two-year period ending January 22, 2009, a beating well beyond anything it had seen before. We believe that the massive sell-off of investment-grade corporate bonds has gone too far and that the asset class offers an attractive investment opportunity at current, historically wide spreads.
In the first seven weeks of the new Obama administration, a fiscal stimulus package has been passed and a far-reaching budget reform bill is waiting in the wings. Attention has naturally focused on how these initiatives will impact the economy, and an overview of the likely effects is presented here.
With the broad stock market down nearly 50% since December 2007, some institutional investors are considering rebalancing their portfolios, shifting fixed-income allocations to equities to re-attain the equity exposure they would normally target (that exposure having declined because of the drop in equity valuations). We believe such a response is much less appropriate now than might have been the case after past sell-offs.
Recently, the question has arisen as to how the Term Asset-Backed Securities Loan Facility (TALF) and Public-Private Investment Program (PPIP) facilities will affect the balance sheet of the Federal Reserve (Fed). Answering this question is useful not just for its own sake, but also for providing perspective on the Fed's activities since September 2008. In this white paper, we first explain the Fed's balance sheet and then relate this issue both to Fed policy setting in general and, more specifically, to the Fed's actions so far this year.
Some analysts currently recommend that institutions move to passive-only exposure in fixed-income while maintaining active management in equities. In order for such tactics to be advisable, an investor should have a firm conviction that positive active returns—or alpha—can be reliably obtained in equities and only in equities. Evidence supporting that conviction would be a finding that information ratios for equity managers thoroughly dominate those for fixed-income managers.
In the months following the financial system's near meltdown in September 2008, the Federal Reserve (Fed) injected massive amounts of liquidity into the financial system to lower private-sector borrowing rates, stimulate growth in the money stock and generally assuage stress on the economic system. In the wake of these operations, speculations abound about whether and how the Fed will be able to reverse the monetary stimulus without generating rising U.S. inflation and without disrupting financial markets.
The view among most of the Wall Street crowd is that the pace of consumer spending will be the critical factor determining the strength of U.S. economic recovery in the next few years. Their story is that the consumer has been the linchpin of all postwar recoveries, the current recession was consumer-led, and U.S. consumers will therefore need to lead the economy into recovery. The catch is that with consumers in deleveraging mode, the Street fears that growth in consumption and GDP will remain sluggish for the foreseeable future.
The Chinese economy has undergone a V-shaped rebound in its growth trajectory in 2009. The latest GDP release for 2Q09 shows a sharp rebound expanding 7.9% year-on-year (YoY) compared to 6.1% in 1Q09. The Chinese government's timely and aggressive stimulus policies put in place last year have been instrumental in reviving the economy. To recap, the government implemented a massive RMB4 trillion fiscal stimulus package late last year while the reserve requirement ratio and lending rates were slashed a respective 200 and 220 basis points (bps) in the aftermath of the Lehman Brothers collapse.
We believe that inflation volatility should remain well above levels established during the past 25 years, a period admiringly described as the Great Moderation. This is not a one-off threat stemming from quantitative easing or the current financial crisis. We believe inflation volatility will likely be a continuous concern over the next business cycle and beyond. Given this increased uncertainty, the need for inflation insurance is greater than ever.
Global imbalances-large trade deficits in advanced economies offset by large trade surpluses in emerging economies-dominated policy discussions until early 2007, when the immediate threat of global financial collapse displaced this massive medium-term challenge. Today, after lying dormant for two years, the debate is reviving and appears to be more consequential than ever: there are compelling arguments that global imbalances contributed to the financial crisis.
Some commentators are recommending that investors restrict fixed-income allocations to passive mandates, confining active management to equities or alternatives. In a 2009 white paper, "Active Equity and Passive Bonds?", we pointed out that in order for such an approach to be advisable, information ratios for active equity managers should thoroughly dominate those for active fixed-income. We found that actual results did not support this. If anything, active fixed-income information ratios were superior to active equities.
Emerging-market debt has outperformed many major asset classes on a risk-adjusted basis over the past 15 years (Exhibit 1). As illustrated by the historical Sharpe Ratios in Exhibit 1, hard currency sovereign debt (represented by the Emerging Markets Bond Index Global, or EMBI Global, and the Emerging Markets Bond Index Plus, or EMBI+), hard currency corporate debt (represented by the Corporate Emerging Markets Bond Index Broad, or CEMBI Broad) and local market debt (represented by the GBI-EM Global Diversified) all look favorable relative to the performance of high-yield debt, stocks (represented by the S&P 500) and US Treasuries.
The current consensus forecast for the US economy is for growth to proceed indefinitely at a rate of 2-3%, a rate equal to currently accepted estimates of long-run potential (trend) growth going forward. If the economy were at or reasonably near to full-employment, trend growth would make sense. However, the economy is nowhere near full-employment; it is more depressed than at any time since the Great Depression. From such a depressed state, 2-3% growth would be, in effect, a "no-recovery" recovery.
By now, liability-driven investing (LDI) has become a household name among defined-benefit pension (DB) plans worldwide. Major DB global accounting and regulatory reforms occurred some years ago, making DB plans more acutely aware of the short-term volatility in their funded balance, and we have since seen a proliferation of DB efforts to engage in various LDI tactics such as liability matching, dollar-duration matching, swap overlays and more.
While details remain thin, it seems likely that China will re-introduce the crawling peg that existed from July 2005 until July 2008, at which time a parity of 6.83/USD was fixed. During the following three years of managed flexibility, the yuan gained 21% against the US dollar (it lost 8% against the euro). Appreciation expectations are more modest today. Non-deliverable forward (NDF) contracts imply an appreciation of around 3% over the next 12 months against the dollar, up from near 0% a month ago but still below the expectations seen earlier in the year. More bullish forecasters call for closer to 5% appreciation in the next year.
The location of the 2007-2009 financial crisis is more remarkable than its magnitude. Financial crises of similar magnitude are inherent to the development process "as countries struggle to transform themselves from emerging markets to advanced economies." However, the current crisis erupted in advanced economies, not emerging markets, and had nothing to do with a struggle along the development spectrum. Domestic failings were undeniably involved in the run-up to the worst crisis to afflict advanced economies in 75 years.
The landscape of the global sovereign debt market has changed drastically since the problems in Greece first arose earlier this year. Markets have been incredibly resilient in the face of these issues, with the effectiveness of Europe's response to the crisis far exceeding what were fairly dire expectations. However, it was the emergence of these problems at the sovereign level that served to highlight a number of risks that had, to that point, been underestimated-from the presumption of currency union infallibility to the stability of a banking system with substantial holdings of sovereign debt no longer considered to be risk-free.
There is near universal consensus among Wall Street analysts and Washington policy-makers that the US experienced a significant slowing in economic growth in recent months, a phenomenon commonly referred to as a soft patch. No less prominent an observer than Fed Chairman Ben Bernanke has stated publicly and flatly that the pace of growth has slowed and that the Fed is contemplating further stimulus.
The credit crisis that began in 2007 reminded us of some lessons about risk management that we may have forgotten, but it didn't show that fundamental principles have to be rethought. In fact, the credit crisis emphasized the importance of those very same principles, three of which we believe to applicable always and everywhere: prediction is very difficult, especially if it's about the future; investing is not a game, and clarity is imperative.
There have been a multitude of news stories over the past few weeks discussing foreclosure moratoria actions taken by several banks in various states across the country. While the news media seems particularly focused on the "robo-signer" issue, other issues relating to the foreclosure process have been raised and continue to draw attention to loan servicing processes. Western Asset's non-agency mortgage team is constantly monitoring how the nuances of mortgage servicing impact both the mortgage market as a whole, as well as the long-term value of our securities.
Capital is pouring into emerging markets. For those who remember the "boom and bust" cycles of the 1980s and 1990s, this is nothing new. However, the catalysts that fostered the gradual build-up and rapid reversal of foreign capital inflows during those periods are markedly different from those driving the wave of liquidity towards emerging markets today.
Low government interest rates do not necessarily imply inflationary monetary conditions; indeed, a low nominal interest rate may be a sign of expected disinflation and restrictive monetary conditions. With this in mind, recall that the last time interest rates were as low as they are today was during the 1930s and 1940s. That phase was characterised by the aftermath of the Great Depression and the misguided constraints of a disintegrating gold standard.
After a month-long campaign of preparing the financial markets, the Federal Reserve (Fed) has moved forward with plans to attempt to further stimulate the economy through additional asset purchases, known as Quantitative Easing Part II, or QE2. It will expand its balance sheet by $600 billion over the next eight months. The Fed has defined its schedule of purchases across maturities fairly precisely, and most purchases will occur within the maturity range of two to 10 years.
The fear of rising interest rates seems ubiquitous these days. One driver of this fear is the belief that US inflation is set to take off, thanks to the US Federal Reserve's (Fed) second round of quantitative easing (QE2). But there is quite a gap been perception and reality concerning the Fed's QE2 policy.
Motivated by a combination of heavy government debt issuance and aggressive monetary accommodation, investors in the US, Europe and Japan are becoming more interested in the merits of overseas diversification. Certainly, most investors are severely underinvested in markets outside of their home countries. This so-called "home bias" has been measured extensively, and its size has long been a puzzle. Unfamiliarity with international markets is cited as the chief explanation of the seemingly irrational decision to concentrate assets based on geographic proximity.
Issuance of U.S. dollar-denominated bonds by corporations headquartered in the emerging world began to rapidly increase six years ago. Emerging market governments began to balance their budgets, let their currencies float more freely, significantly reduced their external debt, and became large global net creditors. As the supply of external sovereign debt declined significantly, these economies experienced a significant increase in GDP growth as a result. Moreover, as many governments began to aggressively retire their external sovereign debt by redirecting financing towards budding local currency markets (please see our paper entitled "Emerging Market Debt: It's Not Just the EMBI Anymore!"), the crowding-out of corporations by their respective governments in the external markets was significantly reduced. The void created by the absence of sovereign issuance was quickly filled by corporations with significant capacity constraints but limited local financing opportunities.
As we embark on a new investing year, we are hearing concerns from investors regarding their fixed-income allocations. Conventional wisdom is: a) reduce duration, as interest rates are likely to rise, and b) increase liquidity to protect against systemic risk. While we are not convinced that rates will move significantly higher in 2011, we do acknowledge that it is a risk. The chances of another systemic event are also real and are worthy of consideration. So what should an investor do? One thing we can recommend with confidence is that investors continue with active management.
Insurance industry regulation and financial reporting are undergoing significant reform. For example, the upcoming European Solvency II regulatory regime embraces a market-consistent approach to the valuation of an insurance company's balance sheet and capital position. Capital requirements are calibrated based on economic risk; this brings transparency to the market-consistent value of insurance companies' capital positions and risk exposures.
Emerging markets (EM) have been attracting more investor attention and money flows recently. But investing in this asset class is not a new trend at Western Asset. Emerging markets have been a part of our US Core Full Discretion product since 1993. In this Q&A, Portfolio Manager Matthew Duda talks about emerging markets at Western Asset and discusses opportunities in the emerging market corporate asset class.
Much has changed since messengers on bicycles physically delivered Government National Mortgage Association (GNMA) certificates around lower Manhattan on GNMA delivery day. The settlement of mortgage-backed securities (MBS) is now almost completely electronic, yet current market conditions have recently resulted in increased MBS trade settlement failures, or "fails." It is important to understand how and why an MBS fail occurs and what costs it poses to investors.
Japan was struck by the largest earthquake in its recorded history, followed by a tsunami that exacted a devastating human toll. To compound matters, the tsunami knocked out the backup cooling systems at the Fukushima Daiichi nuclear power plant, leading to explosions in multiple reactor units and radiation exposure for tens of thousands living in the area. The potential fallout from the nuclear incident is highly uncertain and continues to drive market pricing.
The US economy has been in recovery for over 18 months, with GDP growth averaging about 3% over that period. While that pace exceeds what most forecasts were looking for two years ago, disappointment with the pace of recovery is rampant, and that is understandable given the fact that unemployment rates are still very high. This paper attempts to reconcile the facts and the sentiment. We analyze where the recovery has been satisfactory, where it has been deficient, and where stronger growth is most likely to emanate from, if the recovery is to attain the 4%-5% growth pace that would be required (temporarily) to bring unemployment back down to acceptable levels within an acceptable time frame.
Many defined benefit pension plans have expressed concerns about the prospects of rising interest rates and the impact on their fixed-income assets. This white paper proposes that perhaps the environment that many defined benefit plans should be concerned with is not that of rising yields but that in which yields precipitously fall due to a systemic shock. The typical defined benefit plan's funded status has already experienced negative volatility from this very scenario a few times just in the past decade. To protect against this scenario, plans can buy insurance against the negative impact of falling yields by, in effect, purchasing a call on rates (so that the value of the option rises as rates fall). This allows the plan to benefit from additional duration should rates head lower.
Access to the global markets is of ever-increasing importance. Some investors may be looking to draw on a mix of sectors and asset classes within their own borders while also diversifying globally. Western Asset Management Company's Global Multi-Sector (GMS) strategy is intended to enable just that. For over 15 years, this strategy has provided access to the global fixed-income universe and has aimed to reduce overall volatility by combining investment-grade corporate and government bonds with high-yield and emerging markets.
It is well known that long-duration bonds are the low-risk asset for defined benefit (DB) pension plans. By increasing allocations to fixed-income and extending duration on those assets, plans can reduce the volatility of their funded balance. This paper is the first in a series dealing with the endgame of such efforts, the issues a DB plan faces when it attempts to reduce risk to an absolute minimum.
Despite a clear trend toward greater exchange-rate flexibility during the second half of the 20th century, the countries of Western Europe chose to go against the global consensus, forming the largest network of fixed exchange rates since the gold standard. Seventeen countries with a combined population of more than 325 million have fixed their exchange rates to one another using the most durable - some say irreversible - means possible: adopting a common currency managed by a single central bank.
The first quarter of 2011 saw record rates of covered bond (CB) issuance. Outstanding euro-denominated CBs (based on the Bank of America Merrill Lynch EMU Broad Market Index) totaled more than €900 billion at quarter-end. We are following this market closely, looking for investment opportunities in the sector and assessing its impact on other areas of bank capital structures.
In our January 2011 US High-Yield Investment Report, we wrote, "We believe that high-yield managers will differentiate themselves during 2011 through issuer selection." We expected that volatility would decline, performance disparities between rating and industry categories would be fairly muted, and issue selection would be the driving force that differentiated manager performance. Year-to-date (YTD) through June 6, 2011, the difference in total return among rating categories is down 39% and the difference in total return between industries is down 72%. Meanwhile, the difference in total return between the best and worst issuers is over 8,600 basis points (bps). These are market conditions in which investment management firms with strong credit teams can separate themselves from the pack.
There has been substantial coverage of the possible default of US Treasuries (UST) in the media and by Wall Street analysts. This discussion is driven by the need for politicians to raise the limit on issuance of US federal debt (e.g., UST). In 1917, the US Congress created a law that gave it the authority to set a limit on the amount the US government can legally borrow. The debt limit is the total amount of money that the US government is authorized to borrow to meet its existing legal obligations, including Social Security and Medicare benefits, military salaries, interest on the national debt, tax refunds and other payments.
Moody's warning on Wednesday, July 13, that the US might lose its AAA rating as a result of the debt ceiling issue has prompted some questions regarding the impact of such a development on emerging markets. We believe that this "noise" has been with us for quite some time. Moreover, major structural problems exist not only in the US, but elsewhere in the developed world; these problems are widely known and reflect serious global imbalances that are challenging countries on the economic offensive and defensive fronts.
In what seemed like a replay of the dynamic that ultimately forced Greece, Ireland and Portugal out of private capital markets, investors began pushing yields on Spanish and Italian debt toward unsustainably high levels beginning in mid-June. Reacting to rumours that he could be forced out of the government, Italy's finance minister, Giulio Tremonti, declared, "If I fall, then Italy falls. If Italy falls, so falls the euro." While the first link in his chain of causation is suspect, the last is not. Spain and Italy are both too big to fail yet too big to rescue, and Europe's monetary union would not survive a disorderly default by either nation. Once again, the global economy seemed perilously close to the edge of the precipice.
Steve Walsh shares his thoughts on the recent volatility in the markets, the outlook for growth, issues in Europe and the downgrade of the United States.
In a low-rate environment, more high-yield companies are looking to refinance their bonds to a lower coupon level. How can an investor potentially profit from this trend? Western Asset's Short-Dated High-Yield strategy targets bonds that are more likely to be tendered before their first call date - at a premium. Using bottom-up quantitative and qualitative analyses, Western Asset has identified short-duration high-yield bonds (typically with call protection expiring in the next two years) that are more likely to be called early.
The European Union recently approved new regulation on mutual funds called UCITS IV (Undertakings for Collective Investment in Transferable Securities, fourth edition). UCITS IV, which is patterned on regulatory risk requirements for banks, provides two approaches to regulatory risk management of a fund's portfolio: the Commitment Approach and the Value-at-Risk (VaR) Approach.
In this Q&A, Senior Research Analyst Robert Abad describes recent developments in the emerging market space, the risks that investors need to be aware of, and why Western Asset is well positioned to benefit from the changing dynamics within this market. In contrast to previous periods, external factors are increasingly driving risks within emerging markets. However, emerging markets have demonstrated an ability to weather broad market shocks, such as those that occurred in 2008.
Our outlook for the US economy is that growth will continue to muddle along, neither accelerating to a boom nor deteriorating to a double-dip recession. One reason we are not as negative as most Wall Street analysts are presently is that we don't believe that there will be significant drag on the economy from either the ending of the US Federal Reserve's (Fed) second round of quantitative easing (QE2) or from the expiration of various fiscal stimuli. We believe the end of these programs will fail to exert any substantive drag on the economy because they failed to substantively stimulate the economy when they were imposed. There are sound economic reasons to assert that recent monetary and fiscal stimuli did not have any actual stimulative effect.
The term "Shangri-La" never fails to evoke imagery of Oriental mysticism. Originating from English author James Hilton's 1933 novel Lost Horizon, Shangri-La was the fi ctional Tibetan monastery bearing utopia-like qualities, where four Westerners sought refuge after a plane crash-landing. While geographically isolated and immune to the sociopolitical turbulence then prevailing in the outside world, Shangri-La nevertheless drew heavily, in a material sense, from the world around it. Within its grounds were contemporary features, including central heating and a grand piano, as well as bathtubs from Akron, Ohio.
At the sovereign level in the developed world, market action over the last few years has been dominated by growing concerns about liquidity and solvency risk, which have been partially validated by numerous developed-country sovereign credit-rating downgrades and progressively weaker headline economic data over the last 18 months.
In a new Q&A, Western Asset CIO Stephen Walsh discusses Western Asset's Total Return Unconstrained (TRU) Bond strategy. Formerly called Absolute Return, TRU Bond seeks to maximize returns by using the broadest cross-section of Western Asset strategies.
There are good reasons to question whether traditional bond indices are meeting their primary objectives as benchmarks in bond portfolio management. This white paper presents some alternative approaches to benchmarking fixed-income portfolios.