August 2013 – Monthly Commentary

The fixed income market saw massive redemptions suffered by the largest fixed income mutual funds over the last several months.  The highly visible spokesmen for those funds have appeared in the media with increasing frequency stating and restating their bullish stance, while simultaneously selling bonds to meet rising redemptions.  That hefty selling need, approximately $41 Billion, or 14% of the assets of the flagship fund, over the last four months at the largest bond manager, has weighed on the fixed income market, and has resulted in mark-to-market losses on securities that we deem to be attractive investments.  Given our high conviction on the value of those securities, we expect that the spread widening will reverse in the coming months, turning those mark-to-market losses into gains.  As anticipated, our hedging program has offset the interest rate sensitivity of the portfolio, and we believe will continue to provide downside protection as interest rates rise.


The catalyst behind the selling has been the gradual realization that the Federal Reserve will announce in September a reduction in the purchase of Treasury bonds in the secondary market; the so-called taper.  Since first mentioned in May, investors have debated “will they or won’t they” taper, seemingly ignoring the consistently better than expected economic data witnessed with each successive release.  As it stands, we expect that Chairman Bernanke will confirm that the Open Market Committee will begin to taper purchases commencing in October and expect that those purchases will be trimmed by $15 to $20 Billion per month.  In addition, we’ll look for clues as to timing of further tapering and the Fed’s thinking on an ultimate rate hike, which is likely to be deemphasized by the Chairman.


Reacting to the anticipated tapering, emerging markets have continued to suffer significant collateral damage.  For the four months ending August 31st, the two darlings of the emerging markets, Brazil and Mexico, have suffered significant losses in their bond markets and the value of their currency versus the U.S. Dollar.  For the period, the Brazilian Real and Mexican Peso have fallen, 19%, and 10.30%, respectively.  Similarly, the local currency denominated 10-year Treasury notes issued by Brazil and Mexico have fallen in price by 18% and 9.1%.  For dollar-denominated investors, that translates into losses of 37% and 19.4%.  Recall that earlier this year, money was pouring into those investments under the thesis that everything that was wrong with the developed markets was right with the emerging markets.  They were net exporters with budget surpluses, their economies were growing strongly, and after years of sky-high inflation, they had achieved relative price stability.  The inflow of cash was so great that on several occasions the Brazilian government took steps, including taxing the Real at time of conversion, to dissuade “hot money” speculators from buying into Real denominated investments.  That entire dynamic reversed when the Fed mentioned the prospect of tapering.  Much of the investment had been driven by macro hedge funds and the pursuit of yield in this world-wide low interest rate environment.  Those hedge funds deduced that the intention to taper open market purchases would be followed by an outright increase in interest rates.  With an increase in rates, the U.S. market would become attractive again so it would be prudent to sell emerging market debt and repatriate the currency back to U.S. dollars before other investors did so.  What transpired is similar to what happened when investors fled ETF’s earlier this year.  Sellers overwhelmed the market and buyers emerged only after valuations had plummeted.  While emerging market debt can, at times, play a role in the fixed income asset class, investors need to understand that liquidity can disappear in the blink of an eye.  Despite the fall in price of the bonds and the currencies, we do not view emerging market debt as a buy at this time.