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Related Insight

Consternation and Convexity – A Silver Lining Playbook?

CONSTERNATION AND CONVEXITY – A SILVER LINING PLAYBOOK?

March 2021

We believe recent bond market volatility and the corresponding steepening of the yield curve could be teeing up a favorable entry point for long-term fixed income investors.

With optimistic trends in COVID-related hospitalizations and vaccinations, investors are increasingly focused on the second half of 2021 and the growing strength of the U.S. economy. While consumer discretionary and related services industries continue to struggle, the manufacturing and housing sectors are driving GDP growth expectations for 2021 well above 5%. Survey and market-based measures of inflation rose in anticipation of Congress passing significant additional fiscal stimulus measures. This improving outlook has led to a steepening of the yield curve and other shifting bond market dynamics (Exhibit 1).
Despite the headline move in these various data points, volatility shook markets during the last week of February as results of the month’s 7-year U.S. Treasury (UST) note auction were released, which suggested tepid investor demand. Equity markets weakened on this news, particularly technology-related shares, and the 10-year UST note yield briefly pushed above 1.6%. UST yields stabilized and trended lower the following day as many investors appeared to view the rates market as oversold. While financial markets could be susceptible to additional shocks from increased interest rate volatility, we believe the Federal Reserve (Fed) is committed to ensuring the economy continues on a sustainable path to recovery.

Exhibit 1

10 yr_2yr_chart1
10yr_UST_Chart3
All data for the period of 12/31/20 – 02/28/21
Source: Bloomberg L.P.
MOVE_Chart4
10 yr_2yr_chart1
10yr_UST_Chart3
MOVE_Chart4
All data for the period of 12/31/20 – 02/28/21
Source: Bloomberg L.P.

The Federal Open Market Committee (FOMC) remains steadfast in its favorable disposition towards accommodative monetary policy for the foreseeable future. The majority of FOMC participants expect the targeted fed funds rate to persist at the lower bound of the current range of 0.00% – 0.25% through at least 2023. Moreover, the Fed has reiterated its commitment to the ongoing expansion of its balance sheet through monthly purchases of $120 billion in UST and Agency mortgage-backed securities (MBS) until inflation and employment measures make substantial progress towards its long-term targets. In fact, during his Congressional testimony on February 23, Fed Chair Jerome Powell stated, “the economy is a long way from our employment and inflation goals.” If changes in interest rates were to cause materially tighter financial conditions or threaten the economic growth outlook, the Fed could pivot to a more accommodative policy by extending the maturity profile of its ongoing purchases.

The recent move higher in rates has not been isolated to the United States. The market value of the Bloomberg Barclays Global Aggregate Negative Yielding Debt Index has fallen to roughly $13.5 trillion, down from a peak of more than $18 trillion in late 2020. This remains elevated on a historical basis and highlights the comparative attractiveness of the U.S. market for international buyers. In addition, the demand for long-duration yield could increase as projected improvements in pension funding ratios may lead to rebalancing in order to de-risk plan portfolios.
Bond Markets - Drum Roll Please…
As the global interest rate environment remains challenging, we believe it is important to remind investors there are a variety of sources of fixed income returns besides yield. First, a steeper, positively-sloped UST curve increases the opportunity for total return related to “roll.” Meaning, if interest rates stabilize, a fixed income security will benefit from the passage of time as it moves down the curve; the steeper the curve, the greater the potential related return. As illustrated in Table 1, the roll component of a bond’s total return can be significant. In this example, we use a theoretical 1-month annualized return of UST securities to demonstrate the impact of roll.
This concept is amplified in the credit sector where off-the-run securities (e.g., a 4-year or 8-year maturity) trade to a reference on-the-run UST benchmark (in this example, the 5-year and 10-year, respectively). This increases the calculated spread of a security relative to the nearest UST maturity and increases the total return opportunity from spread tightening.
Table 1
Roll Effect – A Theoretical Illustration

UST Securities, as of 2/28/21

Annualized 1 month_Chart5
Source: Bloomberg L.P., PNC Capital Advisors
It is also important to consider recent bond market performance from a historical perspective. We analyzed 30 years of Bloomberg Barclays Aggregate Index data to try to put this recent period of market underperformance into context. As shown in Table 2, losses of greater than one percent over a corresponding period occurred 32 times over the last 30 years. In each instance, the index generated a positive return over the following 12 months. At the end of February, the index had a trailing 3-month total return of -2.02%.
Table 2
Historical Analysis of 3-Month Underperformance Periods
Bloomberg Barclays Aggregate Index, as of 2/28/21
Trailin 3 month_chart6
Source: Bloomberg L.P., PNC Capital Advisors
In recent years, fixed income investors have been unaccustomed to negative portfolio returns. However, based on our analysis of historical bond market selloffs, periods like the last few months have historically offered an attractive entry point. As we illustrated, a steeper yield curve can create opportunities for total return from roll by extending portfolio maturity profiles. A steeper yield curve should also generally result in greater compensation per unit of risk for fixed income investors. Taken together, this environment has the potential to broaden the investment universe and therefore improve portfolio diversification and increase comparative relative value. Examples include both high quality Agency MBS as well as investment grade corporate credit. Given the supportive backdrop of a strengthening economy and continued support from both fiscal and monetary authorities, these sectors are an area of focus for appropriate client strategies.

Important Disclosures

BLOOMBERG® is a trademark and service mark of Bloomberg Finance L.P. and its affiliates (collectively “Bloomberg”). BARCLAYS® is a trademark and service mark of Barclays Bank Plc (collectively with its affiliates, “Barclays”), used under license. Bloomberg or Bloomberg’s licensors, including Barclays, own all proprietary rights in the Bloomberg Barclays Indices. Neither Bloomberg nor Barclays approves or endorses this material, or guarantees the accuracy or completeness of any information herein, or makes any warranty, express or implied, as to the results to be obtained therefrom and, to the maximum extent allowed by law, neither shall have any liability or responsibility for injury or damages arising in connection therewith.

This publication is for informational purposes only. Information contained herein is believed to be accurate, but has not been verified and cannot be guaranteed. Opinions represented are not intended as an offer or solicitation with respect to the purchase or sale of any security and are subject to change without notice. Statements in this material should not be considered investment advice or a forecast or guarantee of future results. To the extent specific securities are referenced herein, they have been selected on an objective basis to illustrate the views expressed in the commentary. Such references do not include all material information about such securities, including risks, and are not intended to be recommendations to take any action with respect to such securities. The securities identified do not represent all of the securities purchased, sold or recommended and it should not be assumed that any listed securities were or will prove to be profitable. Past performance is no guarantee of future results.

PNC Capital Advisors, LLC claims compliance with the Global Investment Performance Standards (GIPS®). A list of composite descriptions for PNC Capital Advisors, LLC and/or a presentation that complies with the GIPS® standards are available upon request.

PNC Capital Advisors, LLC is a wholly-owned subsidiary of PNC Bank N.A. and an indirect subsidiary of The PNC Financial Services Group, Inc. serving institutional clients. PNC Capital Advisors’ strategies and the investment risks and advisory fees associated with each strategy can be found within Part 2A of the firm’s Form ADV, which is available at https://pnccapitaladvisors.com.

© The PNC Financial Services Group, Inc. All rights reserved.

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INVESTMENTS: NOT FDIC INSURED – NO BANK GUARANTEE – MAY LOSE VALUE

  • Corporate credit generated the largest average excess return, but exhibited greater volatility and higher overall interest rate risk (as measured by effective duration).
  • Agency MBS had an average spread comparable to that of corporate credit with considerably lower return volatility and interest-rate risk.
  • Consumer ABS offered the lowest overall interest rate risk, as well as the lowest volatility of return.

Next we examine each of these sectors in more detail.

CORPORATE CREDIT

We focused our analysis of the corporate credit sector on investment-grade securities, defined as BBB-rated and above. The profile of the corporate credit index can be deconstructed into two primary factors that describe risk and return: default risk and spread duration risk. We define default risk across three quality buckets: AAA-AA, A, and BBB. These ratings represent the average rating assigned between the primary credit rating agencies. Similar to modified duration, which measures a bond’s price sensitivity to changes in yields, spread duration measures price sensitivity to changes in credit spread. We believe it is a good proxy for duration risk of excessreturn, as opposed to duration risk of totalreturn (modified duration).

The table below shows excess return, volatility, and MIRs over various credit quality and bond maturity segments.

Return

  • BBB-quality categories have had the highest average excess returns. Additionally, the A-quality segments have outperformed the AAA-AA tier in all maturity groups less than 10 years.
  • Longer-maturity segments have not necessarily driven larger average annual excess returns. In fact, across credit quality groupings, the 5- to 7-year maturity category has generated the highest excess returns.
  • The 10-plus-year maturity group had the lowest mean returns across the maturity landscape. Lower realized excess returns can be partially explained by demand from asset-liability managers and insurers with long-term liability targets. Demand from this investor base has compressed spreads in longer-dated securities and flattened credit curves. In addition, longer spread duration amplified the price impact from changes in risk premiums, which led to a greater proportion of time periods exhibiting negative excess returns than other maturity segments.

CORPORATE CREDIT Continued

Volatility

  • Within all credit quality segments, longer maturities resulted in substantive increases in return volatility; larger spread durations at longer maturities amplified volatility.
  • Lower credit quality was also associated with increased return volatility across maturity categories. The table Spread Between Minimum and Maximum OASillustrates the wide variation of risk premiums among these segments over the past 22 years, as measured by option-adjusted spread (OAS).

Modified Information Ratio (MIR)

  • While shorter-maturity groupings have generated the most attractive risk-return profiles (the highest MIRs), the magnitude of average annual excess return in these segments is generally limited.
  • Lower-quality and longer-maturity credit have the potential to provide opportunities to maximize excess return.

STRUCTURED PRODUCTS

Between 1997 and 2019, AAA-rated ABS and agency MBS sectors exhibited significantly less volatility of excess return than nearly all credit sectors, resulting in compelling MIRs. Additionally, there was a low correlation of excess return between structured products and the corporate credit sector over the 22-year period, due in part to the high-quality and shorter-duration profile of structured products relative to the overall credit index.

We believe structured products provide an important source of diversification and can improve the risk-return characteristics of an overall portfolio. The diversification benefit provided by incorporating structured products in an asset-allocation strategy can be illustrated by comparing two portfolios, one consisting solely of government and credit sectors (Bloomberg Barclays Government Credit Index) and the other that includes structured products (Bloomberg Barclays Aggregate Index).

As shown in the following table, adding structured securities to a government-credit portfolio over the period 1997 to 2019 would have produced an enhanced average annual excess return, a reduction in return volatility, and a higher MIR.

When constructing a portfolio, there are additional aspects of the MBS and ABS sectors to consider.

MBS

  • Interest-rate volatility has the largest impact on relative performance of MBS. The inherent prepayment-convexity risk of these securities affects the timing of cash flows from monthly amortization of principal and interest.
  • The MBS and corporate credit sectors are driven by different economic and market dynamics: interest-rate volatility (MBS) versus business fundamentals and corporate default cycles (corporate credit).

STRUCTURED PRODUCTS Continued

ABS

  • While the ABS market has very little exposure to prepayment volatility, and relative performance is not interest-rate driven, the sector has shown a low correlation with credit overall due to limited exposure to the corporate business cycle.
  • Additionally, ABS securities benefit from structural enhancements that boost credit quality. These include cash reserves, overcollateralization and/or subordination, which can mitigate the loss potential for investors at the top of the capital structure.
  • Structured securities can play an important role in optimizing the risk-return profile of a fixed-income portfolio.
  • The enhanced income and relatively low volatility historically offered by AAA-rated consumer receivables make the sector an important component in the construction of a risk-focused portfolio.
  • We believe the credit card and prime auto segments of the ABS market are high-quality, liquid asset classes with an attractive risk-return profile.

OUR COMMITMENT TO OUR CLIENTS

We believe opportunistic sector allocation, coupled with an investment process focused on risk management and identifying relative value opportunities should result in consistent risk-adjusted returns over a full market cycle.

Over the last several years, we’ve experienced a wide variety of interest rate and risk regimes. We’ve adhered to the tenets of our risk-based philosophy throughout and used these opportunities to evaluate the findings of our historical analysis in practice.

Insight Blotter

Still on Track: SOFR In, LIBOR Out

We provide an update to the team’s previous commentary regarding the phase out the London Interbank Offered Rate (LIBOR) in favor of its heir presumptive, the Secured Overnight Financing Rate (SOFR).

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