Currently work as a fixed income portfolio manager. Spent time in NYC in both investment banking and equity research. Current CFA charterholder. Plan to periodically blog on bonds, macro, and individual stocks. Follow me on twitter at @davidschawel
A lot has been made of the track records of Bill Gross and Dan Ivascyn managed funds since the sudden departure of Gross from PIMCO. Mainstream media has covered the aftermath in great detail, but explanations of the performance have gone relatively untouched. Was the performance of Bill Gross really that awful? Was it entirely attributable to a poor call on US Treasuries? Is the Ivascyn magic touch now about to change all of PIMCO’s bond funds? Let’s sort through the facts and establish some pragmatic views on the subjects.
1. Ivascyn knocked it out of the park
Make no mistake about it, the management of Dan Ivascyn’s funds the since the crisis has been nothing short of superb. The PIMCO Income Fund (PIMIX) is up an average of 12.8% over 5 years versus the category average of 7.2%, ranking it better than 99% of peers according to Morningstar. Fund assets grew from $300mil in 2008 to $6.5bil at the end of 2011, and now $38.6bil at the end of September 2014.
Ivascyn and co-PM Alfred Murata targeted beat up credit assets that would benefit from a reflating of the financial markets. As central banks moved interest rates to zero and removed government bonds from the system, investors were forced to incrementally move out the credit curve.
An example of something that PIMIX has owned and done extremely well on is Spanish Covered Bonds. This is one the larger holdings in PIMIX. As shown, in three years, the price has risen from ~50 cents on the dollar to ~120 as the Euro debt crisis calmed.
Arguably the largest source of returns for the PIMCO Income Fund has been from non-agency MBS. There’s been arguably no better place for outsized returns in fixed income than non-agency MBS since 2009. Ivascyn and team made shrewd bets that these assets would recover and they did.
All in all, Ivascyn’s bets have been credit related and have centered around risk premium compression in the junkiest areas of credit. He has not been without misses - as his PIMCO funds held large amounts of Brazilian entrepreneur Eike Batista’s bankrupt OGX, as well Mexican homebuilder Homex. The point is not that he got a few wrong, but that he bet big on a recovery in the weakest areas of the credit markets and has largely been correct. Gross himself recognized & apparently liked this opportunity set as he is the largest owner of the Ivascyn managed PIMCO Dynamic Income fund (I consider it a leveraged version of PIMIX) with over 1.6mil shares held.
2. Gross’ Total Return Fund was not comparable to Ivascyn’s Income Fund
The objective of the PIMCO Total Return Fund is to "maximize total return, consistent with preservation of capital and prudent investment management. The fund invests at least 65% of its assets in investment grade fixed income".
The objective of the PIMCO Income Fund is to "maximize current income and to seek for long-term capital appreciation…"
These objectives are not anything similar to each other. The Gross managed Total Return Fund by mandate must seek preservation capital and may only hold a maximum of 35% in non investment grade bonds. In contrast, the Income fund is seeking to maximize current income and long term capital appreciation. Gross was forced to hold a substantially larger amount of government bonds and lower yielding IG credit.
3. Even if he wanted to, the Total Return Fund was too large to buy the bonds that Ivascyn bought
Peaking at $293billion, the Total Return Fund is an absolute behemoth. Bottom line is that the types of bonds which had the most outsized returns (such as non-agency MBS) were not able to be purchased in great enough size to move the needle.
The size of the entire non-agency universe has fallen to under $750billion. After accounting for legacy holders, hedge funds, and banks, the universe to buy is very small. As an example, the large Maiden Lane auctions where the Government sold off amounts of non-agency MBS were only around $7bil if I recall correctly. If the Total Return Fund bought that whole thing it still would’ve been a very small allocation to the fund.
4. The performance of the Total Return Fund was largely based on duration calls
With a fund so large as Gross managed, the relatively performance of it came down to his call on duration. It’s been well documented that he was wrong about US rates a few years ago and that lack of duration hurt his relative performance. Regardless of QE or “the new normal”, his views on how much duration to take was the big determinant. He bet that rates would rise and inflation would as well (Gross funds were heavily long TIPS).
Yes, Gross and team made some mistakes but comparison to Ivascyn’s funds are misleading. They were playing in very different areas of the bond market and the size of Gross’ Total Return Fund were a big headwind. Astute readers will note that Ivascyn isn’t on the PM team for the Total Return fund & that’s probably a smart choice. Ironically, as Gundlach mentioned yesterday, the biggest mistake that Gross made might have been letting his flagship fund get too large.
There’s a lot happening underneath the surface in the markets right now and I thought It would be worth highlighting a few of these things.
Inflation Expectations Plummeting
Above is the 5yr inflation breakeven. As you can see, the annual inflation expectation has fallen from ~2.10% per year in July to ~1.65% today. This is a substantial drop in expectations. There’s nothing in the current inflation data to indicate that, at the margin, expectations should be plummeting. That being said, the market looks to be somewhat taken off guard by the FOMC’s higher than expected Fed Funds forecast for 2016 & 2017. This “tighter” Fed is driving much of this IMO.
Below is the chart for 5yr real yields. Goes without saying, but falling breakevens & rising nominal yields have caused real yields to shoot higher. As shown in the chart, 5yr real yields at 15bps are at their highest level in over 3 years.
This is a surprise to nobody, but the dollar has been on an absolute tear with the DXY rising from 80 to 84.72 since July, but the move is actually fairly small in a longer historical perspective. The US economic cycle is much further ahead than other developed economies right now. In the US there’s actually discussion about a rate hike while other places such as Europe the discussion is centered around further easing & fighting deflation.
The dollar strength has been broad based and has also included the Yen. The USDJPY has resume its upward climb and stood over 109 as of this morning. At current levels there’s a substantial gap in inflation expectations between the two economies. In Japan 5yr inflation breakevens are ~2.3% while as discussed, in the US, they are at ~1.65%. There’s been a lot of promises from Abe and the BoJ, but I am skeptical of this inflation materializing.
As of 6/30/14, Japan’s current account balance moved to negative 0.12% of GDP after being positive for the last 20+ years. Part of this is the fact that Japan has had to import high cost energy after having to take the nuclear reactors off line. If/when the nuclear power comes back, this should materially help Japan’s current account deficit and may potentially be a tailwind for Yen appreciation.
The chart of gold looks pretty bleak but I think there’s a number of reasons for this. Many of the “memes” that gold bulls have pointed to are now gone or are coming to an end. QE, which some erroneously coined as “money printing” and inflationary, is coming to an end. Second, inflation is low and inflation expectations have plummeted as shown above. Third, the dollar has materially strengthened. Now this doesn’t mean that gold can’t go up, or won’t go up, but many of the reasons commonly cited by gold bulls have now gone by the way side.
"We learned a little bit more about the Fed’s intention on exit strategies in this week’s minutes. As expected, the Fed is leaning towards IOER as the main policy rate and the RRP playing a supporting role. The Fed plans to set the RRP rate "at or above 20bps" below IOER. Interestingly though, most participants also felt the Fed Funds Effective rate should also be examined and the calculation should be amended to obtain a more "robust measure of overnight bank funding rates." Which was an odd reference because we’ve learned post-crisis that setting the IOER rate doesn’t control the Fed effective rate. Mainly because GSE’s and a few non-bank institutions do not receive interest on their reserve balances. Incentivizing these counterparties to lend in the Fed funds mkt at rates well below IOER and widening the IOER/FFeff spd. GSEs now account for a vast majority of lending into the fed funds market. It wasn’t initially clear to me why the Fed was focused on the Fed effective calculation in the mins though. But after a little research, and seeing Lockhart’s comments today, it certainly makes more sense. The federal funds rate, is currently calculated on the basis of "brokered trades" of overnight loans of reserves between banks. However, this excludes "direct trades" and "eurodollar transactions" which is anything outside of the broker platform. Fed Funds are not traded on our desk but I would guess that meant a large portion of the overnight lending activity was not currently being captured in the effective calculation. "The Fed has already started collecting this data from 165 domestic banks and U.S. branches of foreign banks since 4/1st." Hard to tell what kind of an impact this will have on lending rates but it definitely makes sense that the setting should include all trades, something that needs to be fixed before official exit strategies are determined."
The rate rally on the long end of the curve this year caught most big investors by surprise but Doubleline’s funds were well positioned. Gundlach’s funds had exposure via last cash flow mortgage bonds and “Z” bonds which price off of the 10yr or further point of the treasury curve. With the 10yr down ~50bps YTD, these bonds have had substantial price appreciation.
Looking at some updated holdings as of May month end, I noticed that Gundlach and team took down duration by selling out of many of the aforementioned long duration bonds. While this shouldn’t be a declaration that “rates are going up”, it’s interesting to see that Gundlach who has been bullish on longer duration bonds has started to pare back exposure.
I tweeted a few thoughts last night on lingering questions of how the Fed will eventually drain reserves. The more you look into this, the more problematic it becomes. On the bright side (or the dark side?), maybe things won’t improve enough where they’ll need to drain reserves and this whole “fear” will be null and void. The following are tweets of mine from last night on these topics:
The thing about TDF: goal is to reduce reserves from the system so their demand for reserves will force them to borrow from interbank mkt
Now think about that: banks will need to voluntarily enter into term deposits w hope that they’ll need demand for those at a “natural” rate
Reserves were added by brute force (purchases) so you can’t expect banks to have a demand to borrow them b/c they’ve locked them away in TDF
Would you put all your excess liquidity in a bank CD so that you’d have to borrow if something came up? Therefore TDF cannot be primary tool
Projecting the price at which participants will enter RRP is a fools game. No price for liquidity when you need it, esp in HQLA environment
Banks & Fed now forever intertwined in a big way- mass implications for functionality of banks & credit flow w all Fed exit options
Speaking at an investor conference yesterday, Citigroup CEO Mike Corbat noted that they may finally be able to sell their OneMain Financial unit which is housed in Citi Holdings. This is interesting from a number of different angles including the resurgence of consumer lending as well as the path of global investment banks post the global financial crisis.
It is no secret that large banks have been hit with an avalanche of new regulations since the crisis including Dodd-Frank and new Basel III rules. Systemically it’s understandable that regulators and policymakers looked back upon the previous banking system and saw great risks which they wanted to “fix”. We are now almost six years past the crisis and the very institutions that are in position to help with the recovery are arguably being stifled from doing so.
This example of Citigroup and OneMain clearly shows how risk in the system is being transferred and who some of the new actors will be going forward. The reason that Citi has been reluctant to part with OneMain has to do with funding. Citi as a bank can fund the high yielding (usually 20%+) loans of OneMain financial with their deposits which have a very low cost of funds in this ZIRP environment. A private equity buyer wouldn’t have the luxury of “free deposits” to fund with, thus the economics to them are substantially worse. OneMain’s competitor, Springleaf, which i have written extensively about funds their loan book with a mixture of corporate debt and asset backed securities.
We’re in an environment where net interest margins are under pressure, and Citigroup is going to eventually part with high yielding loans from OneMain at an uneconomic price. Again this is true because any non-bank buyer cannot fund these loans at the levels that Citigroup can. There’s broader implications here, as private equity institutions such as Fortress, Blackstone, and KKR appear to be taking on risks (and rewards) that were previously reserved for the high powered investment banks. Is this a good thing that risk in the system is being shifted away from TBTF institutions? Maybe, but in the interim it’s clear that big banks such as Citi are being forced to move away from profitable business lines where they enjoy advantageous funding to appease regulatory scrutiny.
Every quarter or so I survey twenty people in a wide variety of market occupations for their market views on the coming quarter. In order to force their hand and be decisive, I allocate three “investment units”. The three choices are the S&P 500, the 10yr UST, and cash. They may choose three of one, and none of the others, or some combination. Short positions are not allowed.
As you can see below, the results show that bullish sentiment has decreased fairly dramatically since the survey was last done in late November. The shift has gone from stocks to cash as allocation to the 10yr UST has mostly stayed the same. All in all, participants are allocating 47% to cash, 37% to the S&P 500, and 17% to bonds.
Fresh off a year where major equity indices are up 25-30%+, many would suspect it might be difficult to have strong bullish conviction on equity names in 2014 but I couldn’t’ disagree more. To be clear, I don’t have a strong opinion on equity markets as a whole, but secular trends are setting up to provide fantastic opportunities for significant capital appreciation over the next few years in certain sectors.
There’s a number of things that I won’t be banking on for these particular plays. First, these plays are not dependent upon certain factors staying in place which have led to elevated corporate profit margins, namely weak wage growth. It’s very likely the coming years will see wage pressures rising which will undoubtedly place margin pressure on a variety of companies which have reaped the benefit of sluggish wage growth caused by extreme slack in the labor markets. Second, these plays are largely not dependent upon valuation multiples staying or going above historical averages. All things equal, the segments I want to be most exposed to are ones tied to a pickup in consumer lending and a renewal of the securitization markets.
Bank Disintermediation Creates Opportunity in Non-Prime Lending: In early November I did a deep dive into Springleaf Holdings (LEAF) which is a non-prime consumer lender. All the ingredients are there for Springleaf to continue to excel. Upside exists in their legacy real estate segment for incremental losses to be lower as home prices recover and employment picks up. Competition from large TBTF like financial institutions has all but evaporated as regulators force the banks to stick to their core businesses. Regulatory risk does exist in the form of potential CFPB rulings, but Springleaf appears far more friendly than so called “payday lenders”. Despite the recent run-up in Springleaf’s stock price, I believe the company can earn $2.00 per share in the not too distant future pushing the stock up to roughly $30. Aside from Springleaf, one of my favorite plays now is JGWPT Holdings (JGW) which is the brand name in the structured settlements industry. After a busted IPO a few months ago, the company is primed to earn $2.25-$2.50 per share all the while only trading at ~$17. I think the stock can trade to $22-$25 as the story become more well known.
Bet on a phasing out of the GSE’s and a return of non-agency MBS securitization: Pressure continues to mount for the government to become a smaller part of the mortgage market. The equity plays that will do best in a scenario where reliance upon the GSE’s is reduced are interestingly priced very attractively. A company such as Redwood Trust (RWT) will benefit greatly from a surge in non-agency securitization issuance as their Sequoia securitization shelf would be front and center. The stock took a hit this summer as the bond selloff created an air pocket in securitization. Longer term there’s catalysts for a return of issuance including a reduction of the conforming loan limit from $417k, higher G-Fees, and increased loan level pricing adjustments. All of these things are very positive at the margin. Private mortgage insurance is another segment that might still have legs heading into 2014. Currently the FHA/VA share of mortgage insurance is at 64% versus 20% in 2007. The FHFA has no desire to remain such a large percentage of this market. Instead of more popular plays like RDN or MTG, I am bullish and long Essent Group (ESNT) which a new fast growing private mortgage insurer with no legacy issues. Other names in this space that I like for next year include PennyMac Financial Services (PFSI) where the GP aspect is being far undervalued, and Stonegate Mortgage (SGM) which is on track to build up a large MSR book while trading at only 5x EPS in the meantime.
Small Banks: The best optionality out of all of these picks may indeed be in small banks. Banks have struggled with loan growth as they’ve made a “student body left” from real estate loans to C&I loans. If there’s any froth in lending I believe it’s occurring on the C&I side and not the Real Estate lending side, thus all else equal I’d prefer a larger exposure to real estate. That being said, there are a number of very attractive risk reward opportunities available in sub $1bil banks which are trading at or near 1x tangible book. Many regional banks are trading close to 1.9x TBV but if you’re willing to do the work you can find plays such as First Citizens (FCNCA) trading just above 1x TBV but with credit quality metrics (0.83% NPAs/Assets) and profitability (4.30% LTM net interest margin) metrics in excess of larger peers. The positive optionality for banks comes in the form of interest rates as most banks are asset sensitive. For many banks as short term interest rates rise, the yields on their assets will rise quicker than the costs of their liabilities (deposits). As this happens net interest margins will expand and costs will be spread over a much larger revenue base. There’s nothing wrong with owning a bank at a reasonable multiple with a ROE of 8-10% in this rate environment, but the real upside comes if rates rise and book multiples expand as profitability takes off.
The financial services industry is very different than pre credit crisis but I believe very good opportunities exist in the above companies headed forward due to a number of secular themes. The phasing out of the GSE’s, return of securitization, and return of consumers taking on debt should all be powerful drivers of these companies. Arguably the best part is that these plays aren’t priced for these things to happen, so you’re buying in at arguably very cheap valuations. It’s daunting to make stock picks after a year such as 2013, but great potential exists here, and it’ll be fun to watch.
***The views expressed here are mine alone and do not reflect the views of my employer***
Putting aside the impact of the Fed’s LSAP’s (and tapering) on the level of long term interest rates, I’ve held on to a few different trends as to why I believe a material rise in interest rates is unlikely in the near future. Said a different way, various data series have signified to me why the potential of the recovery is limited all else equal.
I closely watch the growth of commercial bank loans outstanding. One could argue the shift to non-bank lending makes this metric less important post the great financial crisis, however it is still one of the most pure indicators of credit creation in the financial system. Anyone who has tracked the Fed’s H8 report (asset & liabilities of the top 25 banks) has noticed a paltry growth trend in outstanding loans. In short, excluding a reclassification in 2010, total loans and leases are still below levels seen in 2008.
Part of this is easily explainable. For instance, real estate loans declined precipitously since 2008 due to defaults and has only recently started to climb again. Meanwhile since the GFC commercial banks have made a “student body left” out of real estate loans and into “C&I” loans. The C&I sector has been the main driver of loan growth while consumer & real estate lending languishes. Fast forward to this past Friday where we saw a material $25bil week over week increase in bank loans & leases. Is this jump just noise or the start of something greater? After seeing YoY growth levels fall through this summer, we’re now seeing a reversal of this. This is a bullish sign and something that’s been lacking.
Also released on Friday, we saw consumer credit rise materially above consensus expectations. Unlike the recent past where the increase was primarily driven by student loans, a large amount of the pick up was in the revolving credit segment. Again, this is something we haven’t seen in some time now. There’s been an overall reluctance to take on debt in the consumer segment.
QE has caused base money to explode as reserves are added to the system through bond buying all the while broader measures of money supply have grown tepidly. This could be changing if recent trends in consumer credit and bank lending are any indication.
Should employee wages start to gain traction we could see monetary velocity pick up materially. Guillermo Roditi recently wrote a great piece which posited that wage growth could soon be on the horizon: http://blog.morallybankrupt.org/2013/12/profit-margins-tax-receipts-and-labor.html Either way, we should be paying close attention to credit creation and if last week’s data were any indication, higher velocity and therefore higher interest rates could be in store.
The first “Twitter Smart Money Survey” didn’t turn out to be so smart in the end. Participants were largely neutral on stocks at the end of June as the responses were roughly evenly split between stocks, bonds, and cash.
As a refresher, I ask participants to tell me their hypothetical allocation for the next three months between the S&P 500, 10yr UST, and Cash. They can choose 1 part of each, or any combination.
At the end of June with the S&P500 at 1,665 and taper fears running rampant participants had only a 38% allocation to the S&P500 with 32% to the 10yr UST and 30% to Cash. Now with the S&P over 1,800 participants have a 57% allocation to the S&P. The cash allocation has stayed flat at 30% while the bond allocation has fallen to 13% from 32%.
The second part of the survey was new and involved answering 4 yes or no questions.
1.Concerns about high valuations are warranted: Yes or No
70% of people responded “Yes”
2. I feel under-invested equity wise at the current moment : Yes or No
Only 10% said they feel underinvested
3. I feel this period of low interest rates (ZIRP environment) changes what PE multiple I believe stocks should trade at: Yes or no
75% of investors said yes.
4. I expect 10y USTs to have a positive total return over a 1y horizon
45% expect a positive total return. This is interesting considering that only 13% want any exposure to the 10yr.
All in all despite stocks rising dramatically poll participants now want greater exposure to the S&P despite 70% of people saying that concerns about high valuations are warranted. 75% of people think that this environment warrants higher PE multiples. Are participants too bullish? No way to know but compared to the last survey this group of professional investors are dramatically more bullish.