Sifting Through the Junk
Sam Park - March 2006
Follow the Money
In our previous report, we mentioned how changes to pension accounting rules
may induce pension fund managers to change their over-weighted equity
allocation. Some analysts estimate that between $250 billion and $600
billion could flow out of the stock market and into the fixed income arena
due to changes in pension accounting rules. Furthermore, we've witnessed
inconsistent behaviors in yields offered on various maturity classes - particularly the flattening and inversion of the yield curve. This report
will discuss the various factors that affect rates on yields and the current
issues that may have been playing an influential role in the U.S. fixed
Three primary types of risk make up what's known as credit risk. These risks
include default, credit spread, and downgrade risk. Default risk considers
the borrower's ability to meet obligations on a timely manner. Credit spread
risk questions whether the credit or yield spread on a particular fixed
income security will widen compared to a benchmark yield (i.e. Treasury
yield). Downgrade risk weighs the effects on the price of the fixed income
security when downgraded by credit rating agencies.
One of the first things considered when conducting credit analysis, one goes
over the "four C's of credit analysis." They include character, capacity,
covenants, and collateral.
Character - Management's quality and its ability to make right decision
(particularly on the commitment to repay loans).
Capacity - Company's financial flexibility and liquidity (i.e. cash flow
influences and short-term assets).
Covenants - Agreed terms and conditions between the borrower and lender. Two types of covenants include affirmative covenants (promise of the borrower to
meet certain promises like paying interest, principal, taxes, etc.) and
negative covenants (restrictions to the borrower regarding what actions are
Collateral - Uncommitted assets offered as security.
Several key financial ratios are utilized to examine the borrower's ability
to meet debt obligations. These ratios may encompass variety of solvency
ratios, capitalization ratios, among others. An analyst would compare these
ratio results with some benchmark range. This process resembles much like a
comp analysis. However, using ratio analysis has drawbacks such as it
typically applies historical or current numbers. To conduct forward-looking
analysis, some of these numbers could be adjusted for projections.
Cash flow analysis applies future influences into calculations. Numerous
cash flow models exist, however, the key is to use the appropriate cash flow
measure for whatever is being analyzed or valued. For debt analysis
purposes, discretionary cash flow represents the appropriate cash flow,
which is the cash flow available after funding basic operating requirements.
Pension Obligation Components
High-yield (junk) bonds typically offer the highest rates among the fixed
income securities. Despite the relatively high yields offered, these
instruments have higher probability of default. Before buying into these
instruments, purchasers thoroughly review the issuer's debt structure,
corporate structure, and covenants.
The usual debt structure of high-yield issuers encompass bank debt, bridge
loans, reset notes, senior debt, senior subordinated debt, and subordinated
debt. Bank loans are typically short-term, have floating rates, and have
highest claim against the issuer's assets. Brokers typically underwrite
bridge loans, which represent intermediate-term loans. Coupon rates on reset
notes reset periodically, affecting cash flows with changing interest rates.
Senior debt involves the use of coupon bonds, deferred coupon bonds or
zero-coupon bonds, and maturity of such bonds is closely monitored. Senior
subordinated bonds have one higher priority to assets than the subordinated
bonds. Analysts observe how issuers service subordinated debt, especially if
the company pays coupon with proceeds from additional bonds.
Why is the corporate structure of the issuer important? Well, it is critical
to understand who does the borrowing, where the funds go, and who generates
the debt payments. The usual high-yield issuer has a holding company
structure. Remember, the parent company borrows the money, but its
subsidiaries generate the cash flow to pay the obligations. Simply looking
at the parent's financial does not reveal the issuer's true ability to pay
its obligations. Therefore, a thorough analysis of each subsidiary remains a
A look at the issuer's (including the subsidiaries') covenants may
distinguish fact from fiction. The covenant will dictate what the company
can, cannot, or must do. Covenants also provide clues as to what management
will do if faced with potential problems.
Other Fixed Income Securities
Asset-backed securities (ABS) differ from corporate bonds, mainly because
collateral represents the most important aspects of an ABS. Cash flow comes
from such collateral and flow through the various tranches (bond classes) of
the ABS. The collateral pool of assets may consist of mortgages or some
other securitized assets. The quality of the ABS depends highly on the
ability of the underlying debtors to pay their obligations and the ABS
servicer to administer the collection and payment efforts.
Mortgage-Backed Securities (MBS) resemble ABS; however, real estate
properties back MBS. Mortgage borrowers typically make monthly payments that
get channeled to MBS holders who have the right to the property in case of
Municipal bonds come in two forms: tax-backed (General Obligation or "GOs")
debt and revenue bonds. Tax-backed bonds typically depend on the
municipality's overall debt burden, budgetary policy, tax base, and other
local economic environment. State and local governments use revenue bonds to
finance particular projects. These bonds resemble corporate bonds in that
the quality of the issue depends on the ability to generate revenue.
Therefore, analyzing revenue bonds is similar to the process involved with
Sovereign debt involves the obligations of governments of nationalities
other than the U.S. Economic, and political risks mainly influence the
ability of these governments to meet their obligations. These governments'
integrity may also play a role in their willingness to repay their debt.
This was one of the risks that materialized the downfall of LTCM. Russia's
default on their debt in the summer of 1998 pushed LTCM's woes into a death
spiral. Exchange risk poses another concern, particularly for those issued
as foreign currency debt.
Looking at Interest Rates
The present value of future cash flows (coupons) discounted by the bond's
yield determines the price of the bond. This implies that prices and yields
move in opposite directions. However, the degree of the changes depends on
coupon rate, term to maturity, and initial yield. Lower coupon rates, longer
term to maturity, and lower initial yield tend to experience greater price
volatility with changes in interest rates.
Measuring interest rate risk involves computing prices of bonds under
different required yields. Computed results are compared to current market
prices to determine the degree of price changes. This simple technique
provides a basic approach to assess interest rate risk for option-free
Some bonds have callable and putable features that allow the issuer to call
(buy back) the bond at some agreed price or allow the bondholder to put
(sell back) the bond at a set price. Such options place a boundary to which
the bond prices move with interest rate changes. The duration/convexity
approach offers the appropriate method to estimate interest rate risk for
portfolio of bonds and bonds with embedded options.
Duration estimates the rate of change of the bond price to changes in
interest rates. Since duration reflects a linear estimate, duration has
limitations when measuring larger changes in interest rates. Additionally,
bond price-to-yield relationship has a curved shape - not linear. Therefore,
duration is adjusted by incorporating convexity, which captures the
divergence resulting from the curvature. The combined effect leads to a
better estimate of the percentage price change of the bond.
Term Structure of Interest Rates
The inverted yield curve brings concerns to some of those who focus on what
bond yields may say about the economic outlook. An inverted yield curve
occurs when longer-term yields drop below than that of the shorter-term.
Historically speaking, an inverted curve has corresponded with a decrease in
economic activity. However, several situations differ from previous cases.
As we, and many others, have pointed out, foreign influences may have
contributed to the decrease in long-term rates (i.e. Asian central banks and
institutions buying up their favored 10 year Treasuries, thus driving up
prices and lowering yields). Combine this with the Fed consistently driving
rates up, and then you have the inverted yield situation.
The yield curve typically has a normal yield curve (positive sloping) with
longer-term rates higher than short-term yields. This may be known as "normal" because bondholders typically command higher rates for holding
assets for longer periods. Flat yield curves occur when all maturities have
the same yield.
As we can see, various forces impact demand for particular Treasuries;
therefore, yield curves undergo a variety of curve shape changes and curve
shifts. Furthermore, several methods exist for constructing yield curves.
The most common method involves plotting market yields on recently issued
Treasuries (On-the-Run Treasury Issues). This method is relatively simple;
however, the available Treasuries limit the data points and do not include
the yields in between the standard maturities. Including off-the-run (bonds
issued before the recent issued bonds) helps overcome this gap issue. Linear
interpolation and "bootstrapping" can be used to estimate missing yields and
calculate a theoretical spot rate, respectively, to fill the leftover gaps.
Another method consists of the inclusion of all Treasury issues (excluding
callable issues and bond prices with distortions) to construct a theoretical
spot rate curve. Few problems occur when attempting to apply this technique,
such as unavailability of some Treasuries. The final approach encompasses
the application of Treasury strips (zero-coupon securities by "stripping" the
coupons). Problems using Treasury strips include lack of liquidity for
strips (which cause higher premium in rates) and tax treatment disadvantage
(accrued interest on strips despite no realized cash flows, causing higher
Term Structure Theories
Several theories attempt to explain the shape of the yield curve and include
pure expectations, liquidity, preferred habitat, and market segmentation. So
how do these theories explain an inverted yield curve? Pure expectations
theory considers only the expected future interest rates in explaining the
shape of the yield curve. Therefore, an inverted yield curve suggests that
long-term rates will fall in the years ahead. However, various factors
impact the shape of a curve, not just forward rates.
Liquidity theory states that long-term bondholders are compensated for
holding longer-term maturities. Longer-term maturities generally have higher
premiums. This would imply that an inverted curve indicates lower long-term
interest rates than would be the case if liquidation risk was not
Preferred habitat theory rejects the idea that liquidity plays the sole role
in determining rates. Instead, bond purchasers may prefer to match assets
with liabilities in terms of duration. Under such conditions, supply and
demand determine the premium or rates.
The concept behind market segment theory seems parallel to that of the
preferred habitat theory. The main difference comes from the assumption that
under the market segment theory investors consistently stay within their
preferred maturity range.
For instance, Asian countries typically have conservative views when it
comes to handling their assets. This may have influenced them to strictly
stay within the longer-end of Treasury purchases and lock in the rates
(besides, Treasury rates remain much higher than those offered within their
own countries). The imbalance between the supply of short and long-term
maturities would allow short maturity rates to outgrow long maturity rates
here in the U.S. On the other hand, preferred habitat theory assumes that
higher rates on short-term Treasuries will entice investors to shift away
from the longer maturities. Perhaps if the short-term rates rise high
enough, the imbalances will settle out over time.
Recently we have seen the yield curve flatten and slightly invert for a
short period of time. Most notable reasons for the inversion came from the
consistent increases in short-term rates (influenced by the Federal Reserve)
and growing purchases of longer-term bonds by foreign entities. We believe
further rate hikes by the Fed will continue in the near future. The fed fund
futures indicate that market participants expect the fed fund rate to reach
5 percent by the time summer comes around.
The current 2-year Treasury yield remains slightly higher than the 10-year
yield. We believe this trend will continue until the Fed decides to halt
their rate hikes and foreign entities decrease their demand for longer-term
Treasuries. We do not expect the Fed to move much beyond the 5 percent mark
in the foreseeable future; therefore, a deceleration in the short end of the
yield curve will likely come once we enter summer of '06.
The picture of the longer end of the yield curve presents more complex
issues. The following table (see PDF) illustrates the net purchases of long
term Treasury by foreigners.
Positive figures indicate more purchases than sales of long-term Treasuries
by foreigners and imply capital inflow to the U.S. economy. On the other
hand, negative figures would indicate more sales and capital outflow. We can
see that long-term Treasury net purchased had dramatically increased since
2003. This foreign demand for long-term Treasuries may have played a large
role in keeping the long-term yields relatively low.
So, who are really buying these securities? The next chart (see PDF) breaks
down the major foreign holders of U.S. Treasury securities as of January
As of January 2006, foreigners held approximately $2.2 trillion in
Treasuries (out of almost $4.5 trillion outstanding). Among the foreign
countries that own U.S. Treasuries, Japan holds a whopping 31 percent,
whereas China and U.K. represent the next two largest holders with 12 and 11
percent, respectively. The above chart (see PDF) indicates which countries
have influential impacts on interest rates in the U.S. However, a look at
the Treasury purchasing patterns of top foreign holders reveals more
The following graph (see PDF) reveals the Treasury purchasing patterns of
these top four major entities (excluding Caribbean Banking Centers).
This graph (see PDF) uncovers many things above the noise that has been
surrounding the thoughts around the financial community. It appears true
that Asian countries have been steadily buying Treasuries (especially
Japan), but two notable factors can be seen from the above chart. One of
those notable factors includes the accelerating Treasury purchases by the
U.K. The other worthy mention involves the lack of petroleum dollars
funneling back into Treasuries.
We can see that China has been steadily accumulating Treasuries. This may be
the result of China's policy of fixing the yuan, by holding vast amount of
dollars. This trend may reverse as China had indicated that they will move
towards floating the yuan and as the regime has indicated their intentions
to diversify away from the dollar. The move away from the dollar will
depress the currency, and the decrease in appetite for Treasuries will
likely lead to higher interest rates.
As mentioned, dramatic Treasury purchases from the U.K. cannot go unnoticed.
The above chart indicates that purchases rose significantly since mid-2004.
A Bloomberg News report points out that Middle East investors and hedge
funds have channeled their money to British managers, who in turn have
tactically purchased U.S. Treasuries. The report also notes that the
prevalent hedge fund industry in the U.K. causes wide volatility in U.S.
Treasury purchases. Another key observation should be focused on nominal
interest rates in the U.K. The yield curve in the U.K. remains inverted with
the one and two year nominal rates above 4.35 percent and the ten-year rates
around 4.25 percent. On top of the inverted curve, British rates remain
lower than corresponding rates in the U.S. Such discrepancies allow hedging
We shouldn't forget about what OPEC has been doing with its oil revenue.
OPEC purchases of U.S. Treasuries have risen by more than 50 percent, which
reflect the similarly drastic rise in crude oil price. However, with $77
billion, OPEC holdings of U.S. Treasuries are modest compared to the top
three holders. In 2004 alone, OPEC made $349 billion in petroleum exports.
So where's all that money going? As the previously mentioned Bloomberg
report had indicated, Middle East investors have channeled money to British
money managers. Therefore, the recent dramatic increase of U.K. purchases of
U.S. Treasuries may be influenced by the large oil profits from the oil
producing nations. Higher crude prices have lead to higher petroleum revenue
for oil producing nations, and these petroleum profits appear to have made
their way into U.S. Treasuries. On the flip side, lower crude oil prices may
lead to decelerating purchases of U.S. Treasuries.
Wrapping It Up
Investors in fixed income securities look at various factors aside from the
rates promised on such assets. We have mentioned several types of fixed
income securities available to investors with different risk tolerance
levels. Many factors have an effect on these securities, and how such asset
classes are affected depends on the structure of these securities.
Several tools exist to measure and analyze the risks associated with fixed
income securities. We have briefly explained some methods investors consider
when deciding which asset classes to purchase. As China has shown signs of
diversifying outside U.S. Treasuries, the financial authorities in China may
be considering some of the points we've mentioned. Although foreign entities
have options to purchase a variety of fixed income assets in the U.S.,
acquiring U.S. companies may be another story. Nevertheless, who knows how
long Congress can declare security threat to block foreign takeover of U.S.
With all said and done, signs point towards higher interest rates on U.S.
Treasuries. For one, China is expected to move away from Treasuries, and
perhaps into other assets classes mentioned in this report, or even into
other currency denominated assets. This drop in demand for Treasuries would
push down prices, which in turn result in higher yields. Another factor that
may contribute to rising yields comes from the hedge funds in England. U.K.
hedge funds may move out of Treasuries when they anticipate the U.K. yields
to reverse or find assets with better returns than yields on U.S. Treasuries
with comparable risk assessment. One thing is for sure - everyone will
follow the money.
For questions and/or R.W. Wentworth & Co., Inc.'s (RWW) forecasts and
advisory services, contact the following:
Alan J. Rude, President
Tom Au, Executive Vice President
Sam Park, Senior Associate
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