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August 14th, 2012

• Mirror Image of Economy Looks Different to Markets
• Corporate Yields Rise While Treasuries Hold Steady
• Bulls Reveal Hand as 10-Year Finds Support
• The Jackson Hole “Fix” is Not Coming
• Secrets of High Yield Bond Investing Revealed
Mirror Image of Economy Looks Different to Markets
Posted: 13 Aug 2012 09:00 PM PDT
By Rom Badilla, CFA
August 14, 2012
The economic data this summer has looked eerily similar to last summer’s. The ISM Manufacturing Index stood on the precipice of contractionary signals for the U.S. economy in mid-2011 while recent data releases are nearly the same. Furthermore, real GDP Growth for the second quarter for both 2011 and 2012 hovered below the so-called “stall speed” of 1.5 to 2.0% while the Unemployment Rate ticked up during the summer months of the past two years.
Despite the mirror image of the two summers from an economic standpoint, market sentiment has been very different as evident by the subsequent performance of the stock market according to Goldman Sachs’ economist, Andrew Tilton:
Despite the parallels with summer 2011, the market reaction has been quite different. Then, many forecasters (including us) worried openly about the possibility of recession, with a few even making recession their base case scenario. The S&P 500 index tumbled more than 15% and did not return to its springtime highs before early 2012. This year, recession talk has been scarce, the market drop less severe, and the recovery quicker — with the S&P 500 just off its highs for the year (and since the financial crisis).
So what is different this year that is propelling stocks to near-term highs? Goldman Sachs’ research team points out the following factors that are markedly different this time around:
1. Housing activity has picked up considerably. The housing sector is an important “leading sector” with a profound impact on the overall economy, as the financial crisis made plain. Housing starts are up nearly 25% year-over-year; in summer 2011 they were still in the doldrums and some forecasters worried about a major “double-dip” in housing prices.
2. Oil prices look less threatening. Although oil prices have gyrated considerably this year, on net the price of Brent crude is little changed from the beginning of the year (or a year ago). Contrast this with the winter of 2010-2011, when crude surged roughly 50%, from $80 to $120 a barrel.
3. The equity market paints a more optimistic picture. As already noted, the S&P 500 is close to its high for the year, whereas last year the market never recovered its springtime highs. Also, importantly, interest rates are considerably lower. More broadly, financial conditions look fairly supportive for growth–our GS Financial Conditions Index is roughly at springtime levels, near its easiest point for the year; in 2011, it tightened by more than 50bp in the late summer.
A few other factors beyond those included in the model may also have played a role:
4. Lower expectations. Investors had higher hopes for the economy in spring 2011. Our US-MAP score of economic data “surprises” implied about twice as much disappointment in spring 2011 as spring 2012. The scale of the disappointment may have caused investor sentiment to overshoot to the negative side, even though the data were not recessionary in an absolute sense.
5. The “won’t get fooled again” phenomenon. On a similar note, given that last year’s focus on recession turned out to be unwarranted, investors may be less nervous about another weak patch in the data. Evidence that seasonal adjustment distortions may play some lingering role in summertime weakness, particularly for the unemployment rate, may also make forecasters and investors wary of excessive pessimism.
6. No debt limit debacle–yet. The brinksmanship over the debt ceiling in mid-summer 2011 created great uncertainty, and severely damaged business and consumer confidence. While a repeat is certainly possible, investors and managers can at least hope that last year’s searing experience and the end of election season will pave the way for a smoother process this time.
While the research team is able to isolate the reasons for the divergence, they do admit that this model is limited since it does not include market expectations on both European Central Bank and U.S. Federal Reserve policies.
Specifically, concerns regarding the European Debt Crisis have subsided in recent weeks due to the fact that the ECB will institute some major form of bond purchases to rein in escalating borrowing costs for the Peripheries. Also, there are some rumblings that the Federal Reserve will expand their balance sheet and incorporate Quantitative Easing in the coming months in order to prop up asset prices and the overall economy.
As Tilton pointed out, failure for the Central Banks to deliver could disappoint the markets which would lead to another decline in risk assets which in turn would raise the alarm of another recession.
Furthermore, the model does not include the effects of the Fiscal Cliff that continues to loom over the economy at year-end. In the event that a modest correction in equities occurs and a milder form of fiscal retrenchment is implemented that jeopardizes GDP growth, the probability of a recession spikes to 50% by Goldman Sachs’ estimation. Obviously, if the full form of the Fiscal Cliff were to take place, then that probability rises even higher according to their research.
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Corporate Yields Rise While Treasuries Hold Steady
Posted: 13 Aug 2012 02:30 PM PDT
By Rom Badilla, CFA
August 13, 2012
With eyes set for tomorrow’s release of Retail Sales which should improve from last month and may provide a glimpse of the health of the U.S. consumer, there was little activity as the economic data cupboard was bare. As a result, U.S. Treasuries across the yield curve were little changed for the most part.
The yield on the 10-Year U.S. Treasury ended the session at 1.66% which was slightly higher by a basis point from last week. The Long Bond was unchanged as the 30-Year closed at 2.75%. The 5-Year ended at 0.71% while the 2-Year remained unchanged at 0.26%.
In Europe, bonds of developed economies were little changed as well. German 10-Year Bunds finished at 1.40% for an increase of 2 basis points. Both UK Gilts and French Oats followed suit and closed at 1.56% and 2.09%, respectively.
Out on the periphery, debt borrowing costs were better in general. Spain’s 10-Year bonds padded its cushion from the seven percent threshold today as yields fell 7 basis points to 6.84%. Portuguese bonds dropped 3 basis points to 9.94% while Italy’s 10-Year government bonds were unchanged at 5.90%.
While there was little action in the Treasury market, Corporate bonds saw some action as yields increased across the board. The yield on Financial bonds widened by 2 basis points on average while the Industrial sector underperformed as the yield increased by 3 basis points.
Barclays Bank longer-dated benchmark bond was the laggard as the price declined by 0.2% to $107.71 for a yield of 3.91%, an increase of 4 basis points from last week. Large money center banks, Bank of America and JP Morgan, lost less in dollar price as yields for increased by 2 basis points to end the session at 4.01 and 3.22%, respectively.
Comcast, Anheuser-Busch, and Target were the big underperformers of the Industrial sector as yields increased by 5 basis points to 2.66%, 2.43%, and 2.29%, respectively. Kraft and Microsoft were the better performers but still managed to lose 0.1% in price. The yield of their benchmark longer-dated bonds ended at 2.56% and 1.88%, respectively.
Information and quotes provided by Trade Monster’s Bond Trading Center

Bulls Reveal Hand as 10-Year Finds Support
Posted: 13 Aug 2012 09:00 AM PDT
By Rom Badilla, CFA
August 13, 2012
Last week’s selloff in U.S. Treasuries has put in a dent in many bullish bond traders’ wallet and in turn has placed a cloud of doubt over the near-term direction of interest rates.
However for Credit Suisse technical analysts David Sneddon, Christopher Hine, Pamela McCloskey, and Cilline Bain, who continue to favor the broader bull trend, the recent backup was revealing as buyers emerged with last Thursday spike in yields. As a result, the line has been drawn in the sand at the 1.73% level as support. In Credit Suisse’s latest U.S. Fixed Income Daily, they provided the following color:
10yr US yields reverted to test the 1.73/77% support zone – the June chart high and the 38.2% retracement of the entire March-July rally – last week where fresh buying was found. We must allow for a retest of this area. However, we look for it to hold and to see a recovery to test 1.60% ahead of trend resistance at 1.53%. We would look for selling at the latter, but below would expose 1.445% ahead of the 1.38/37% record low/trend hurdles.
Above 1.73/77% is needed for a more significant bearish turn to 1.805/82% ahead of 1.88/92%.

Bond Trading – 10 Year U.S. Treasury
As noted, a retest of 1.73% would provide a buying opportunity with a Stop-Loss set above 1.77% with a target set at 1.60%. This entry point and target of 13 basis points coupled with the duration of the 10-Year at 8.9 years, should equate to a price gain of 1.2% on a one time leverage basis (13bps X 8.9 Years = 1.2%).
While the bulls on the 10-Year part of the curve have revealed their hand, the Long Bond still has yet to show its cards as the yield is searching for support according to the Credit Suisse research team.
The 30yr US recovery on Friday fizzled ahead of trend resistance now at 2.69/689%. This keeps the spotlight on firmer support at 2.83/855% – chart props and the 38.2% retracement of the March-June rally. We expect this to hold and to see fresh buying emerge here. Only above it would signal a more sustained sell-off for 2.97%.
Below 2.69/68% aims at 2.60%. Through here is needed for a more bullish turn to 2.50/49%. Extension through here is needed to retarget the 2.45/44% barrier.

Bond Trading – 30 Year U.S. Treasury
As before, they are flat in their Long Bond exposure but look to buy at 2.83% with a Stop-Loss above 2.855% for a price target of 2.70%. A 13 basis point decline for the 30-Year bond that has a duration of 19.8 years, should equate to a price gain of 2.6%.
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The above content is provided for educational and informational purposes only, does not constitute a recommendation to enter in any securities transactions or to engage in any of the investment strategies presented in such content, and does not represent the opinions of Bondsquawk or its employees.

The Jackson Hole “Fix” is Not Coming
Posted: 13 Aug 2012 07:00 AM PDT
By Walter Kurtz – Sober Look
August 13, 2012
Expectations of a new asset purchase program by the Fed continue to persist as various pundits anticipate its unveiled at the Jackson Hole gathering.
CNBC: – Ebullient stock markets are increasingly pricing in the possibility that the Federal Reserve will soon unveil another round of monetary stimulus, Pimco Managing Director Neel Kashkari told CNBC Wednesday.
“The Fed is really in a box right now,” said Kashkari, who was an architect of the Troubled Asset Relief Program that bailed out major banks during the 2008 financial crisis. Inflation expectations and stocks are at levels that appear to be assuming imminent Fed action, he told CNBC’s “Squawk Box.”
“Those indicators have already priced in … that the Fed should act,” Kashkari said. As a result, the fund manager suggested Fed Chairman Ben Bernanke’s “hands appear to be tied” ahead of a closely watched speech on the economic outlook later this month in Jackson Hole, Wyo.
Market participants are looking for a fix, a repeat of the “high” Bernanke delivered at Jackson Hole in 2010 when QE2 was introduced. Markets however are in for a major disappointment because no outright asset purchases will be announced. There are multiple reasons for this, including the fact that real rates are now deep in the negative territory (as discussed here) and the policy as expressed in long-term real rates is far more accommodative than it was in 2010.
But what makes 2012 entirely different is that the key concern that pushed the Fed into asset purchases in 2010 no longer exists. The summer of 2010 was marked by renewed fears of deflation driven by credit contraction. The Fed was afraid of Japan-style deflationary pressures that are extremely difficult to arrest as bank lending shuts down. In the months preceding the 2010 Jackson Hole speech, credit was contracting sharply with banks steadily shrinking balance sheets. As discussed before, just the opposite is true in 2012 – credit is expanding at a decent pace. The chart below compares the trends now and in 2010.

So what should we expect from Bernanke this time around? It will likely be more of the same things we’ve already heard recently:
1. US economic growth has lost some momentum. Growth in employment has been slow and the unemployment rate “remains elevated”.
2. Europe poses downside risks. A slowdown in emerging markets is also a concern.
3. The Fed will remain vigilant and expects to maintain a “highly accommodative stance for monetary policy”.
4. The Fed is to continue with Maturity Extension Program (Twist) and Reinvestment Policy (reinvesting in MBS to maintain constant balances).
That’s basically it. If the markets are pricing in more from Jackson Hole – which the recent equity rally suggests may be the case – we are setting up for a sharp selloff in risk assets.
CNBC: – “If he doesn’t deliver in Jackson Hole … you’ll see these risk markets react and fall back,” Kashkari said. Investors clamoring for more quantitative easing “suggests there’s downside risk from here if the Fed doesn’t move,”
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The above content is provided for educational and informational purposes only, does not constitute a recommendation to enter in any securities transactions or to engage in any of the investment strategies presented in such content, and does not represent the opinions of Bondsquawk or its employees.

Secrets of High Yield Bond Investing Revealed
Posted: 13 Aug 2012 05:00 AM PDT
By Rom Badilla, CFA
August 13, 2012
Anyone who has invested in the market will admit to the difficulties in navigating through the plethora of information and in managing their portfolios in achieving their objectives. The fact is that while rewarding, bond investing as well as utilizing other asset classes, is quite complex. The saying of “There‘s no such thing as a free lunch” certainly applies here, not just to individuals but to the pros. Evidence shows that even fund managers can have a difficult time in producing returns that exceed that of the market.
Having said this, there are many success stories out there where managers are able to demonstrate an ability to outperform the market and to do so on a consistent basis over the long term. The question is what are some of the “value-added” strategies that managers employ in order to generate alpha?
Citigroup Credit Strategists, Stephen Antczak and Jung Lee attempt to answer this within the High Yield arena by dissecting a number of intermediate to large bond funds by analyzing their individual holdings. In their latest Citi Credit Research – It’s a Credit Picker’s Market Apparently, the two strategists examined the portfolio positioning of 23 High Yield Mutual Funds which on average has outperformed the benchmark by 400 basis points on a year-to-date basis.
When reviewing the general portfolio characteristics relative to the respective benchmarks, nothing really jumps out in terms of differentiation and any major bets. First, this is evident by the average fund trading at a yield of 7 percent which after accounting for the cash holdings is around 6.7% by Citi’s estimation. This average yield is in-line with the High Yield Cash benchmark. Second, the average maturity, which by altering is another source of risk, is comparable with the benchmark’s figure of 6.6 years. Finally, when focusing on the sector positioning of the average High Yield portfolio relative to the underlying index, they see only “modest” deviations.
Despite the apparent lack of bets from a view of 10,000 feet, fund managers were able to employ several strategies that were less apparent at first but allows them to differentiate themselves from the index.
First, Fund managers used out of index bonds that were typically of higher quality as a way to outperform the Junk bond benchmark according to Citigroup’s team of strategists.
We were surprised to see that some of the biggest overweight positions of the typical high-yield mutual fund were distinctly out-of-index, such as select AIG, Sallie Mae, and Bank of America subs and hybrids. In fact, we found that 21 of the 23 funds we examined held bonds from at least one of these issuers.
The two strategists surmised that by using out of index bonds, the strategy of choosing the right credit becomes even more important and provides a broader opportunity set and more avenues to differentiate performance of the fund from the benchmark.
The typical PM took advantage of this larger opportunity set. As noted above, some of the largest longs were in these issues, and they outperformed the broad market sharply despite being more highly rated (Figure 4). These issues accounted for 22 bp of the typical fund’s total outperformance of 37 bp.

The second strategy that bond fund managers employed to outperform was the avoidance of the blowups or “landmines”, i.e. corporate bonds that were in the headline news for all the wrong reasons.
Essentially, this boils down to resisting the temptation to add yield via headline names given how illiquid the market is. In an illiquid market there is no way to tell how far a name could fall in the wake of a negative announcement before a buyer steps in. For example, after SVU’s earnings announcement the 7.45s of ’29 fell over 12 pts before a client buy occurred, and the price was off another 3.5 pts before the next client buy took place.
To better illustrate this general aversion to potential landmines we looked at overweight / underweight positioning of the typical PM for the 20 worst performing issuers in the high-yield market. Of these 20, the typical PM was underweight 16 and only overweight 4 (Figure 1). This is undoubtedly attributable in part to credit picking, but our sense is that it also has a lot to do with very limited appetite for headline risk in general.

Finally and most interesting, another source of outperformance by the average High Yield fund manager lies in bonds with lower yields. That’s right! This finding goes against logic since we all assume that yield equates to return. While true (if bonds are held to maturity) but the fact is that yield is a static number and doesn’t capture the effects of price appreciation when interest rates change.
Picking Junk bonds irrespective of the yield that have the potential to be upgraded in credit ratings can significantly gain in price since yields will decline to match those of its soon-to-be peers in Investment Grade space. So the focus of picking bonds likely to be upgraded aka “rising stars”, comes down to the potential change in yield rather than the absolute level which in many cases were below the yield of the benchmark.
The typical fund also had meaningful exposure to “rising stars.” Although the performance of recent rising stars post the actual upgrade is mixed, by and large performance prior to the actual upgrade has been strong. To illustrate, in Figure 8 and Figure 9 we present the price performance of the F 5.875s of ’21 and the PXD 7.5s of ’20 (both upgraded in May) vs. the market; we see that these issues beat the market by 3.8 pts and 7.5 pts, respectively. And in Figure 10 we highlight the relative performance of HST (a still rising star), and again see strong relative performance.

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The above content is provided for educational and informational purposes only, does not constitute a recommendation to enter in any securities transactions or to engage in any of the investment strategies presented in such content, and does not represent the opinions of Bondsquawk or its employees.

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