CAMS Weekly View from the Corner - Week ending 8/23/24
August 26, 2024
The bond market as a whole is often viewed as the smartest market. Generally speaking it is viewed as such in light of these investment instruments sensitivity to the vast array of socioeconomic/geo-political changes that may unfold.
We offer “may unfold” because the basics of markets is collective participants are always pricing assets today according to what they think they see down the timeline.
Collective bond market participants process a tremendous amount of inputs as they work to bid bond prices today according to what they “see” downstream in light of what their broad swath of inputs are suggesting. Think of it as a large socioeconomic/geo-political digestion machine if you will.
Bond market participation is generally not for the casual participant in particular when price inflation is present within the socioeconomic landscape.
In non-price inflation eras it is easier relative to the inflation consideration because said inflation has proven to be calm and hence increased trajectory of trend is a low concern.
When price inflation is present it offers a tremendous challenge relative to holding a bond to maturity to collect income the bond agreement offers via its stated interest rate.
This fixed agreement – we’ll pay you 5% interest annually for 10 years as an example – is written in stone. If during that time a price inflation era unfolds and price inflation runs 6% annually, as an example, your annual interest payment, when adjusted for price inflation is negative.
Worse, if this hypothetical price inflation era runs for years to the point that your bond maturity is reached the principal you receive back from the issuer, when adjusted for price inflation, equals a sum equating to far less in purchasing power than when you initially invested it.
All told in our hypothetical you end up receiving annual interest payments that are less than the experienced price inflation rate coupled with at the end of the agreement receiving your principal back in negative price inflation adjusted dollars. Put this all together and what do you have?
Certificates of Guaranteed Confiscation.
This is a slang reference to bonds in price inflation eras because wealth is “confiscated” by price inflation if the bond holder keeps the bond certificate until maturity of the agreement.
This is one scenario as to why we offer this “smartest market” is typically not for the casual participant because of the wealth of inputs and risks that must be considered and processed when participating if capital is to be properly deployed and protected.
This is also meant as a succinct example, of which many examples could be shared, as to the plethora of inputs collective bond market participants must process in order to underline this market is not waking up and throwing proverbial darts. They are a focused bunch that monitor and observe a lot of inputs and ask a lot of questions.
With this the messaging they leave in the wake of their bond market operations daily/weekly/monthly etc can offer important collective downstream views of what they are expecting in the general economic landscape. As a result their messaging can be used as tool within a general analytical tool kit.
As We Stand these Participants do not see Imminent Recession
The bond market is made up of a plethora of offerings from corporations, governments and international entities to name a few. In addition the length of maturities offered with desired duration exposure can be selected from a large menu.
Through the vast offerings degrees of safety inherent to an issuer’s ability to live up to their agreements is categorized as well. Rating agencies play a role in offering general categorical levels of perceived risk from X issuer.
This is where we can view how collective bond market participants view the downstream economic landscape. This is done by viewing how various risk categories are trading but also how they are trading compared to one another.
One example is in the corporate bond market. Using two broad categories of perceived risk there are High Yield bonds and Investment Grade bonds.
High Yield bonds have a much higher level of default risk which is why they are known in slang as junk bonds. Conversely, Investment Grade bonds come with ratings offering expectations of low levels of default risk.
If these participants collectively conclude economic recession is presenting itself, “any month now,” they will begin to sell bonds of the issuers that are most economically vulnerable. The High Yield (junk) bond issuers fall under this umbrella as prime candidates. This is especially true when they are compared to the safer Investment Grade bond category.
Importantly - realizing all of these are corporate bonds - if these collective participants fear imminent economic issues even the “safe” Investment Grade bonds will go down in price reflecting concerns of these issuers ability to weather the expected incoming economic storm.
This is why it is important to view how these categories are trading themselves as well as how they are trading compared to one another. Current day both are trading quite constructively as both are hitting higher highs of late. This does not offer imminent recession concerns.
The next question is to ask how are they trading compared to one another for additional economic information as viewed through these collective bond market participants.
Above we place these two categories together via a relationship chart and let them offer their message.
This is a near 20 year chart in order to offer some historical perspective. This is corporate High Yield (junk) bonds to corporate Investment Grade bonds placed together. This means as the line moves downward High Yield bonds are significantly underperforming Investment Grade bonds.
Our red down arrows highlights notable instances of this over the previous couple of decades. Two stand-out timeframes were the 2008/09 Great Recession and the Covid Recession. High Yield bonds were crushed relative to Investment Grade bonds with hard south red down arrows.
Importantly, prices for both categories trended notably south only that High Yield offerings took on more downside as is always expected in light of their increased vulnerability to economic concerns.
Our blue arrow highlights the outperformance of High Yield corporate bonds compared to that of Investment Grade corporate bonds in recent years.
As you-name-it pundit offered “economic demise soon” the bond market via the above measure didn’t concur with such prognostications. When High Yield (riskier category) is outperforming (line in chart trending upward) this is bond market messaging offering little concern for imminent recession.
Our blue arrow offers bond market participants are not seeing a recession downstream albeit our blue circle isolates 2024 which is noting a bit of choppiness in recent months.
While choppiness is present High Yield bonds are outperforming on a trend basis and both categories, when viewing their pricing behavior separately, are trading constructively. As always, this is subject to change which is why we keep an eye on all these types of tools in order to decipher whether messages are changing.
Rest assured, using history as our guide, this will change given time but for now this measure is offering little concern for a near-term recession.
Importantly, expectations via the messaging from bond market operations are not infallible but as offered these collective participants are a focused bunch and are backing their views by deploying billions in dollars of capital rather than only offering an opinion.
For now this indicator is offering no economic recession on the near-term horizon.
I wish you well…
Ken Reinhart
Director, Market Research & Portfolio Analysis
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