Fixed Income Analysis why Private Credit makes sense

Monday, October 6, 2014

Why do different asset classes exhibit such different behavioral patterns?

Consider fixed income analysis or commodities versus equities. Both have similar volatility characteristics over the long term (approximately 18% standard deviation per year) yet their nature is vastly different. Equity bull markets are prone to a slow grind higher – the proverbial wall of worry – yet commodities tend to shoot higher as if all of a sudden the world realizes there is not enough supply to meet demand.

Or how about on the way down?

Equity markets tend to build rather long and large tops before stepping down and waiting – so as to allow the late bulls a chance to buy – and then they move rapidly lower. Commodities tend to build short, sharp tops which look like blow-off tops and then collapse vertically (looks like an inverted V on a chart).

The answer to this question, we believe, is not rooted in fundamentals or technicals, the answer lies in the psychology of the market participants. Simply put, equity markets have many non-professional participants while commodity markets tend to be populated by more professional ‘speculators’. Neither is wrong or better, just different.

Well Greg, that’s all fair and well by what does that have to do with fixed income you say … the answer is that fixed income investors have their peculiar nature too.

Government bonds are subject to speculative buying and selling like any other investment, but first and foremost they are purchased with the aim of earning interest income. As the price of a bond advances its yield-to-maturity declines, and if the price of a bond rises far enough then its yield-to-maturity will fall to zero. This places a virtual lid on the price of a bond (which doesn’t exist on the upside for stocks or commodities or real estate). This virtual lid limits the speed at which a long-in-the-tooth bond bull market can rise and the magnitude by which it can rise, so rather than the bull market ending with a huge upside blow-off followed by a definitive downward reversal, it just peters out over a decade or even longer.

Take a look at the following charts – notice how rates hit a low point and then seem to drift around that point for a decade or more.

fixed income analysis over the last 200 years

Here’s a close up of rates for the 1900’s. Notice how rates bottomed in 1940 and didn’t rise all that much until the mid-1950s – nearly 15 years later.

fixed income market - over the last 100 years

And this phenomenon is not peculiar to US rates only. Japanese JGBs have exhibited similar behavior (yip this is the Queen’s English!) since 1998.

Japanese Government Bonds (JGB) 1998 onwards

The implications are thus important for fixed income investors today. From the chart below we can argue that rates made a secular low in 2012 and only then did the clock start ticking for a decade (or more) before rates will move significantly higher (2022?)

10 Year fixed income analysis over the last decade

Long-term interest rates (the 10yr in this instance) may be range bound between 3.5% and 1.5% for the next decade or longer. Moves down in rates will be predicated upon deflationary scares (as is happening now in Europe) and moves higher inflationary fears (2013 Emerging Market debt in particular).

Overall the HUNGER FOR YIELD that we have experienced since approximately 2010 will not abate for many many years. That means demand for Private Credit (BDCs), MLPs, REITs, solid Dividend Yielding Stocks and practically any other yielding instrument will continue to see strong demand and thus have strong liquidity underpinnings.

Greg Silberman CFA®, CAIA, CA(SA)

Chief Investment Officer

Advisory Services offered through Atlanta Capital Group.

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