The potential for rising rates – and the chilling effect that would have on fixed income returns – is top of mind for high yield investors.
One of the latest signals comes from the general collateral repo market, where rates have hovered negative – a trend that could add to pressure on the Federal Reserve to increase the Interest Rate on Overnight Reserves (IOER) during its meeting next week, said a repo trader and two fixed income market participants. If the Fed does raise the IOER, it would be the first rate increase since a 5bps raise, to 160bps, in January 2020.
A tweak to the IOER would have multiple ramifications across the fixed income markets at a time when USD 1.9trn in stimulus money makes its way to consumers. It would buoy the GC repo market, while shaking up allocations between high yield funds and the white-hot USD 1.2trn leveraged loan market, according to investment professionals across the fixed income markets.
“If yields rise, allocators will start shifting to floating rate from fixed-rate,” said Peter Cecchini, founder of AlphaOmega Advisors, LLC. “That’s bad for high yield funds.”
Meanwhile, the 10-year Treasury yield is the barometer for tightening federal policy – and it has risen rapidly in the last month, noted Daniela Mardarovici, co-head of multisector/core plus fixed income at Macquarie Investment Management. The 10-year yield rose today to 1.62%, from 1.51% at the start of the week and just 0.90% at the beginning of the year.
The high yield market’s historically tight levels likely spell the end of the recent price rally, said Neil Sutherland, a fixed-income portfolio manager at Schroders. The BofA high yield index is now yielding around 4%, in from 11% a year ago as markets sold off in reaction to the burgeoning coronavirus pandemic.
“High yield returns at 4% might be fine on a relative basis, but investors need to be realistic about returns over the next 12 months,” Sutherland added. “The capital appreciation seen over the past year is not possible.”
Meanwhile, in the floating rate corporate world, the return on leveraged loans is 1.78% this year while USD 4bn flowed into loan mutual funds in February—a surge of cash not seen since 2018, said a CLO portfolio manager, citing the S&P/LSTA loan index and Lipper fund flows.
Call the plumber
The pressure to raise IOER above its current 10bps comes from money market funds that typically invest in the GC repo market. When GC repo rates go negative, they can’t invest their cash, said the repo trader. As an alternative, they would have to tap their illiquid investment buckets that incur costs passed onto depositors, said the GC repo trader.
“The main takeaway is that the Fed does not want to have to deal with investors shunning short term investments because they get back less than they invest,” said Glenn Havlicek of GLMX.
Raising the IOER would run contrary to the policy patience that the Federal Reserve has so far signaled to the rest of the bond market, according to an 8 March note from ICAP North America. The Federal Reserve’s primary focus is on the Effective Fed Funds Rate, which has been relatively sticky at 0.07%, according to the ICAP note.
“Raising the IOER relative to the Fed Funds (EFFR), banks would be incentivized to leave more money at the Fed and take it out of the system,” said Havlicek. “This would put modest upward pressure on short-term rates.”
SOFR needs some smoothing
Negative rates in the GC repo market have ramifications for floating rate markets. This is the last year that floating rate instruments such as leveraged loans and CLO liabilities can reference Libor. Three-month Libor declined to 18bps this week from 22bps a month ago, according to the St Louis Fed.
Unlike Libor, SOFR is based on transactions in the GC repo market, which is a key reason why regulators want to transition floating rate instruments to SOFR. But this exposes instruments that reference SOFR to rate volatility in addition to credit volatility, as reported.
On Thursday, the GC repo market opened at 5bps and dipped to negative 3bps, said the repo trader. It opened today at 1bps and offers have fallen to negative 2bps.
That’s a far cry from September 2019 when GC repo rates spiked to 8% following Federal Reserve efforts to shrink its balance sheet, said Cecchini. At that time, the Fed was selling Treasuries before their maturity creating a supply glut, he said.
This time is different. There’s not enough collateral for repo participants. The Fed is holding onto Treasuries until maturity—meaning less supply. So non-dealer participants, like pension funds and government sponsored entities, start chasing all securities, said the trader.
“SOFR is trending negative because there’s not enough supply,” said the trader.
A tight grip on supply to keep short-term rates low is not accidental, said David Knutson, head of integrated research at Schroders. Controlling short-term rates is the Fed’s primary tool that it will hold onto while long-term rates gap out, he said.
This is the setting for USD 1.9trn in federal spending. How rates ultimately behave will depend on whether people spend again. Government transfers via stimulus account for 25% of personal income and it addresses the short-term problems for the market, said Sutherland, referring to government transfers data from the Fed. But bloated money market funds with demand for general collateral repos originates with people reluctant to spend their money, said the CLO manager.
“Government transfers tend to go into savings,” said Mardarovici. “People spend money when they expect income to recur.”
by Seth Brumby