Braced for tapering? Keep waiting

The US Federal Reserve is likely to be slower to start its tapering programme than many in the markets expect, and the process may also be more gradual than anticipated once it begins, says Mark Boyadjian, San Mateo, California-based senior vice president of the fixed income group.

During a visit to Hong Kong last week, he said many investors in Asia (and worldwide) have made new allocations over the past year to floating-rate notes (FRNs) and leveraged loans. The inflows were often because investors assumed the Fed would raise the federal funds rate. The asset size of the firm’s daily liquidity funds roughly doubled year on year.

But these allocations may not meet investor expectations if they are assuming an immediate change in Fed policy. Flows to short-duration assets or to floating-rate instruments are meant to mitigate the impact of a rate hike, but returns in these instruments also depend on Libor, the global benchmark rate at which banks lend to one another, which underpin the loans market. And Libor hasn’t risen; if anything, it has declined this year.

“In a continuing environment of uncertainty over whether the Fed will begin to taper – if the forward guidance suggests a continuation of quantitative easing – then investors who have committed to loans aren’t going to see those income streams rise as they expected,” he says.

Boyadjian’s team oversees high yield as well as FRNs and leveraged loans. He says an extended period of Fed inaction will support emerging-market debt and high-yield bond investors, as well as equity investors, while FRNs and leveraged loans will underperform until the central bank’s policy changes.

This means investors looking to protect themselves from a rate hike need to understand the timing of such a move, and the impact it would have on the performance of various parts of the portfolio.

One tip Boyadjian suggests to measure how markets are bracing for Fed changes is to compare a popular exchange-traded fund for high-yield loans, the iShares iBoxx HYG ETF, versus an ETF for loans, such as PowerShares’ BKLN tracker.

“These are the canaries in the coalmine,” he says. “This is where a lot of investors put their money.” If there is a dramatic shift out of HYG into BKLN, it suggests markets are readying for a more aggressive stance by the Fed.

In the meantime, however, with plenty of money already shifting into FRNs and leveraged loans, the winners have been borrowers in those markets. Boyadjian says most of the issuance over the past year has been refinancings rather than new borrowers.

Citing the political idea of entitlements – such as for healthcare spending – he suggests credit has become seen as a form of entitlement, because of abundant, Fed-generated liquidity. But he is not prepared to say the market has become irrational.

Investors need to look at what each issuer’s plans for the proceeds are to understand whether a refinancing or a new issue is worth it. “The quality of the borrower is about their need, not the market environment.”

So do most borrowers today actually need the money, or are they just taking advantage of low interest rates? “It’s a coin toss,” Boyadjian says, advising investors to be careful if a company is borrowing for, say, a leveraged buyout that is relying heavily on debt and little on equity.

It’s increasingly difficult to evaluate ‘quality’ because of the vast artificial support emanating from the Fed. But this environment may yet persist. The Fed may be anxious to rein in liquidity, but if the underlying economy can’t handle it, and a tightening leads to job losses and further deflation, that could leave the Fed with no option other than returning to asset purchases. Such a retreat would be harmful for its credibility and make a return to orthodox monetary policy all the more difficult.

And recent comments by Fed chairwoman nominee Janet Yellen suggests she is not about to take that risk.