Treasury Yields Post-Covid, Reading Fed Tea Leaves and Junk Bond Intrigue

There were a few notable news items over the last week that should influence your decision-making around interest rates and fixed income. Here are my takes on Treasury yields post-Covid, a Federal Reserve governor's pivot to accommodation and why the story of AMC Entertainment's bond maneuverings may not have a happy ending for anyone. Where will Treasury yields go post-Covid? From both a human and an economic perspective, the best possible news we could get is an effective Covid-19 vaccine. Hence, news on Tuesday that Moderna had a set of very positive trial results is cause for celebration. Let's hope this is one big step toward a post-Covid world. For rate watchers such as me, it begs a question: What might Treasury yields look like after the pandemic is over? Of course, answering this involves a lot of speculative assumptions about what exactly post-Covid means. But for the sake of argument, let's imagine a world where this time next year there no longer is any fear of getting the coronavirus. What would be happening in the bond market? There are three big drivers of interest rates: expected Federal Reserve policy over the time horizon of the bond, economic growth prospects, and inflation. On the Fed, we should assume it will keep its target rate at 0% and probably keep pumping quantitative easing (QE) until the labor market is hot again or inflation is meaningfully above 2%. As I wrote last week, I'd assume that those temporarily laid off due to the virus come back quickly, but there will be another set of normal recessionary layoffs that come back much slower. My assumption is that the best case scenario is that rate hikes wouldn't come until mid-2023, and probably 2025 is more realistic. If we look back at the fourth quarter of 2019, the 10-year Treasury was trading about 20 to 40 basis points higher than the Fed's target at the time. This was before Covid-19, but a period where people didn't think more rate hikes were likely in the near term. If that's the kind of spread that persists, Treasury yields probably won't change much. If we look back to the second half of 2012, a period where everyone knew rate hikes weren't imminent but were coming at some point down the road, Treasury yields were 150 to 175 basis points above fed funds. I picked this period because it was after the eurozone crisis but before the taper tantrum, and thus is probably our best example of the market pricing Fed hikes in the distance without any strong views about how far out those hikes start. I think these two periods form a good band to consider. I think rates being unchanged in a world where we have an effective vaccine is too low, but I also think there are good reasons why 1.75% Treasury yields are unrealistically high. The only thing that reasonably could push us outside of that range would be if inflation really took hold and accelerated above 2% for an extended period. Pivot to accommodation Meanwhile, influential Fed Governor Lael Brainard gave a speech Tuesday suggesting more Fed easing is coming. She started by giving a fairly dark outlook, and then said it was time the Fed pivot from just trying to stabilize the economy to providing more accommodation. Brainard is extremely influential within the Fed. Also, always remember that Fed governors such as Brainard or Richard Clarida are different than the regional Fed presidents such as James Bullard or Neel Kashkari. The presidents are mostly free to speak their minds, and therefore may give an opinion that doesn't reflect the consensus. On the other hand, when a governor speaks, it should be considered an official communication from the entire Fed. These speeches are more closely vetted and the information more purposefully given. When a regional president speculates about some policy action, it is notable but not always meaningful. When a governor speaks, it is always telling. With that in mind, it is important to dissect what she meant by additional accommodation. In the speech this mostly seemed to center around forward guidance. There were two key points she made that probably hint at the Fed's next move. First, she suggested that rates be held near zero until inflation got to 2%. Note that she also didn't include anything about unemployment. Implicity, this means unemployment falling to any level wouldn't cause the Fed to hike if the decline didn't also correspond with higher inflation. Indeed, she said earlier in her speech that policy should not pre-emptively withdraw support based on a historically steeper Phillips curve that is not currently in evidence. That's a reference to what is now viewed as a mistake -- hiking rates in 2015 despite no evident inflation pressure. The second big point was that she brought up yield curve control again. I continue to think this is a policy headed our way. Although the minutes from the Fed's June meeting seemed to throw cold water on the idea, I think a better interpretation is that the Fed needs time to work out the details and doesn't feel any pressure to roll it out because rates are already very low anyway. Regardless, if we assume everything Brainard says is purposeful communication from the Fed as a body, then mentioning yield curve control is very meaningful. Weak covenants + powerful players = danger Everyone knows that junk bonds can be dangerous, but the saga of AMC Entertainment Holdings Inc. shows us why it is getting more treacherous all the time. Here's the short version: AMC was nearing bankruptcy and was attempting a distressed exchange. This is where some set of bond holders agrees to take less than 100% of what is owed, usually in the form of new bonds. Often the new bonds have a longer maturity to give the company more breathing room but also give the bondholders a bigger coupon, some kind of equity participation, and/or a more senior position in the capital structure. In this case, the private equity firm Silver Lake cut a deal where it exchanged $600 million of convertible debt into first-lien debt. In agreeing to this, AMC rejected another offer from other lenders that would have provided more fresh cash to the company but left it slightly more leveraged. As it is, Silver Lake improves its position in the capital structure while diluting the claims of all other lenders. In other words, because Silver Lake's $600 million now is in the first-lien bucket, anyone who was previously in that bucket has a lesser claim. This includes anyone who bought AMC's most recent bond deal, which was sold in May with a 10.5% coupon. Those bonds were issued at $98 but last traded on Tuesday at $82. At the time those bonds were sold, the new buyers seemed to have a first claim on AMC's assets in the event of a bankruptcy. Now they will need to share that position with Silver Lake and get nothing in return for being diluted in this way. Two things readers should take away from this saga. First, when junk bonds get into trouble, big players will be driving the process. I don't blame Silver Lake for its maneuvering; it should do what is best for Silver Lake investors. But if you bought AMC's May bond deal assuming that your legal position would remain status quo, that was a mistake. That isn't how it works these days. And that brings me to my second point. The whole reason why Silver Lake could jump the line in this way is because the May bond deal had so few protective covenants. In the good old days, a first-lien bond such as the one AMC sold in May would have legal language preventing the company from diluting your position unless strict conditions were met. The AMC debt didn't have that. To make a long story short, the junk bond market isn't for the faint of heart. I don't think anyone should be buying individual junk bonds unless you are capable of doing both the financial and legal analysis necessary. If you just want some bonds with extra yield, stick with funds or ETFs.

Treasury Yields Post-Covid, Reading Fed Tea Leaves and Junk Bond Intrigue

A Fed governor speaks of accommodation, and AMC Entertainment's bond maneuvers serve as a warning to those who swim in the high-yield pool.

Columnist Conversation

8 Trading Rules from T. T. Hoyne

This Weekend on Real Money

Classic Trading Rules From Bernard Baruch

COLUMNIST TWEETS

Please Join or Log In to manage and receive alerts.