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BENCHMARK RISK AND PORTFOLIO IMMUNIZATION CONSIDERATIONS DURING A GLOBAL PANDEMIC

BENCHMARK RISK AND PORTFOLIO IMMUNIZATION
CONSIDERATIONS DURING A GLOBAL PANDEMIC

December 2020

Markets are increasingly ebullient on the reported efficacy of several vaccines and the potential for the COVID pandemic to be brought under control in 2021. Despite on-going histrionics, investor appetites were whetted as markets look past the contentious election to a more hopeful outlook supported by continued monetary policy support and the potential for additional fiscal stimulus. While Americans gathered for a non-traditional Thanksgiving feast, market participants gorged on risk assets over the course of November. The Bloomberg Barclays U.S. Credit Index produced over 200bps of excess return during the month with the index Option-Adjusted Spread (OAS) tightening by 19bps to 100bps. Lower quality outperformed, with BBBs besting higher quality investment grade sectors by over 100bps; high yield excess returns approached 400bps.
We share the markets’ growing optimism for a normalization of economic conditions next year. However, we have near-term concerns not just with current developments in the course of the pandemic but, more importantly, the continued evolution of risk characteristics in the corporate credit market that heightens risk/return asymmetry. With more scarce sources of alpha, we believe investors will be rewarded by considering more defensive portfolio risk allocations given current market dynamics. While widely covered in the press generally, we feel it is prudent to highlight three notable developments in the corporate market.

Yield to Worst

Global yields have been pulled lower over the course of 2020 due to slowing economic growth and extraordinary central bank support; the Bloomberg Barclays Global Aggregate Negative Yielding Debt Index is at a record high and approaching $18 trillion in market value. While the Bloomberg Barclays Aggregate Bond Index yield to worst has risen modestly off all-time lows, the move in credit spreads over the course of November has pushed U.S. credit yields to all-time lows (Chart 1).

Quality

With an increasing concentration of BBB-issuance, trends in benchmark credit quality composition have been deteriorating since the Great Financial Crisis. Disruptions to commercial paper markets with the initial outbreak of the pandemic – combined with enticing overall yields on new issues – boosted higher quality issuance in 2020 as overall gross supply reached a record $1.5 trillion (Chart 2).

Duration

Asymmetry is particularly pronounced when considering the duration of the Bloomberg Barclays U.S. Credit Index, which has risen by a remarkable 1.5 years since the end of 2018 (over 20%). Dislocations in short-duration credit, combined with the enticing yield dynamics of longer-term issuance, have incentivized corporations to extend liability maturities. Duration profiles increased due to lower coupons from declining yields and tighter spreads. With a current index OAS in the mid-90s, the break-even spread-widening event that would overwhelm annual carry barely exceeds 10bps (Chart 3).

Conclusion

As we pivot to the turn of the year and eagerly put 2020 behind us, we continue to focus on managing the risk profiles of our client portfolios. This has served us well over the last several years and enabled us to deliver a consistent excess return profile through a variety of market cycles. Broadly, we believe market risk sectors are expensive and expect subsector and issuer selection decisions will present opportunities for incremental alpha in 2021. We appreciate our clients’ on-going commitments to our strategies and wish everyone a healthy and happy holiday season.

Chart 1

Bloomberg Barclays U.S. Credit Index - Yield to Worst

Data from 11/30/2000 to 11/30/2020. Source: Bloomberg L.P., PNC Capital Advisors

Chart 2

Quality Analysis of Bloomberg Barclays U.S. Credit Index

Data from 11/28/1975 to 11/30/2020. Source: Bloomberg L.P., PNC Capital Advisors

Chart 3

Bloomberg Barclays U.S. Credit Index – Modified Adjusted Duration

Data from 11/30/2000 to 11/30/2020. Source: Bloomberg L.P., PNC Capital Advisors

Yield to Worst

Global yields have been pulled lower over the course of 2020 due to slowing economic growth and extraordinary central bank support; the Bloomberg Barclays Global Aggregate Negative Yielding Debt Index is at a record high and approaching $18 trillion in market value. While the Bloomberg Barclays Aggregate Bond Index yield to worst has risen modestly off all-time lows, the move in credit spreads over the course of November has pushed U.S. credit yields to all-time lows (Chart 1).

Chart 1

Bloomberg Barclays U.S. Credit Index - Yield to Worst

Data from 11/30/2000 to 11/30/2020. Source: Bloomberg L.P., PNC Capital Advisors

Quality

With an increasing concentration of BBB-issuance, trends in benchmark credit quality composition have been deteriorating since the Great Financial Crisis. Disruptions to commercial paper markets with the initial outbreak of the pandemic – combined with enticing overall yields on new issues – boosted higher quality issuance in 2020 as overall gross supply reached a record $1.5 trillion (Chart 2).

Chart 2

Quality Analysis of Bloomberg Barclays U.S. Credit Index

Data from 11/28/1975 to 11/30/2020. Source: Bloomberg L.P., PNC Capital Advisors

Duration

Asymmetry is particularly pronounced when considering the duration of the Bloomberg Barclays U.S. Credit Index, which has risen by a remarkable 1.5 years since the end of 2018 (over 20%). Dislocations in short-duration credit, combined with the enticing yield dynamics of longer-term issuance, have incentivized corporations to extend liability maturities. Duration profiles increased due to lower coupons from declining yields and tighter spreads. With a current index OAS in the mid-90s, the break-even spread-widening event that would overwhelm annual carry barely exceeds 10bps (Chart 3).

Chart 3

Bloomberg Barclays U.S. Credit Index – Modified Adjusted Duration

Data from 11/30/2000 to 11/30/2020. Source: Bloomberg L.P., PNC Capital Advisors

Conclusion

As we pivot to the turn of the year and eagerly put 2020 behind us, we continue to focus on managing the risk profiles of our client portfolios. This has served us well over the last several years and enabled us to deliver a consistent excess return profile through a variety of market cycles. Broadly, we believe market risk sectors are expensive and expect subsector and issuer selection decisions will present opportunities for incremental alpha in 2021. We appreciate our clients’ on-going commitments to our strategies and wish everyone a healthy and happy holiday season.

Indices

The Bloomberg Barclays U.S. Credit Index measures the investment grade, U.S. dollar-denominated, fixed-rate, taxable corporate and government related bond markets. It is composed of the U.S. Corporate Index and a non-corporate component that includes foreign agencies, sovereigns, supranationals and local authorities.
The Bloomberg Barclays U.S. Aggregate Bond Index is an unmanaged index composed of securities from the Bloomberg Barclays Government/Corporate Bond Index, Mortgage-Backed Securities Index and the Asset-Backed Securities Index and represent the investment grade, U.S. dollar-denominated, fixed-rate taxable bond market.
The Bloomberg Barclays Global Aggregate Negative Yielding Debt Index represents the negative yielding segment of the global investment grade debt from twenty-four local currency markets. This multi-currency benchmark includes treasury, government-related, corporate and securitized fixed-rate bonds from both developed and emerging markets issuers.

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. 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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  • 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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