The De-Leveraging Supercycle & the Lack of Quality Assets

February 27th, 2013 by

james keeganConventional wisdom is that the market is being flooded with new bond issues.  In 2012, $6.98 trillion in new bonds were issued in the United States. While the market is doing a good job absorbing the new issuance for now, it’s only a matter of time before there is an imbalance between supply and demand. Jim Keegan would not agree. In fact, he thinks there is a shortage of quality assets available to fixed income investors.

Jim Keegan is the Chief Investment Officer of Seix Investment Advisors, which manages $26 billion in assets, including the RidgeWorth Total Return Bond Fund. The fund has a great long-term track record of outperforming its peers and has generated a 5 year average annual return of 6.58%. Learn Bonds interviewed Jim Keegan during the last week of January 2013

 

A 70% Chance Of Greece Leaving The Euro

I asked Jim Keegan about why the Total Return Fund is overweight Treasuries and MBS compared to other intermediate bond funds. He believes that credit assets like corporate bonds have had a tremendous run up and it is time to start taking profits. While he did not know the exact timing, he thinks the market will encounter an inevitable “risk-off” mode in which investors favor more conservative assets. One such scenario which could trigger “risk-off” mode is Greece leaving the Euro. He estimates that there is a 70% chance of that happening within the 12-18 months, but not before the elections in Germany in September. Putting aside Greece, he sees the situation in Europe as very unstable, pointing out that the unemployment rate for young people in Spain is over 50%. With so many young people out of work, there is going to be social and political unrest. By buying high quality assets like MBS and treasuries, he is taking profits and positioning the portfolio defensively as risk premiums have compressed and  a “risk-off” event is not being priced into markets.

 

The Scarcity Of High Quality Assets.

While the market is talking about the amount of new bonds coming to market, Jim is making the case that there is a real shortage of safe assets.  One theme that repeatedly came up during his talk was the global economy, including the United States, is in the early /middle part of the deleveraging process. Households and the financial sector are both lowering their debt loads. I asked Jim Keegan to reconcile this view with the enormous amount of new bond issuance.  He said that much of the activity was related to refinancing existing debt (at very low interest rates) or servicing debt. Jim Keegan estimated that there was only $300 to $500 billion of net “new” investment grade US debt issued last year out of the $1.3 trillion of total corporate debt issued.

At the same time, Jim Keegan pointed out the FED’s buying was limiting the supply of quality bonds.  Between purchasing $45billion of treasuries and $40 billion of MBS every month, the FED will be taking approximately $1 trillion worth of bonds out of circulation a year. The combination of deleveraging and the FED limiting the supply of quality debt is creating a scarcity of quality debt in which the market can invest.

 

Why is Jim Keegan not afraid of the FED’s Zero Interest Rate Policy Creating Inflation?

Many market analysts believe that the FED’s zero interest rate policy will lead to inflation. According to this thinking, the FED will eventually have to raise rates to keep inflation under control. In Jim’s opinion, there is a fatal flaw in this analysis. The FED’s activity is not leading to more economic activity because, low interest rates are not leading to increased borrowing.  The financial sector and the household sector are both trying to lower their leverage and repair their balance sheets. Right now, household debt in the United States stands at around 109% of disposable personal income, after peaking at 130%. Jim believes that this is heading towards below 100%. If deleveraging continues from consumers and the financial sector, the FED’s manipulation of interest rates has little impact. As support for this position, Jim Keegan points to both the velocity of money  and  the money multiplier.

 

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