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.
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.
Bond Markets - Drum Roll Please…
Roll Effect – A Theoretical Illustration
UST Securities, as of 2/28/21
Historical Analysis of 3-Month Underperformance Periods
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Next we examine each of these sectors in more detail.
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.
CORPORATE CREDIT Continued
Modified Information Ratio (MIR)
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.
STRUCTURED PRODUCTS Continued
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.