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MY HERO, ZERO…NOW YOU’RE HERE TO STAY

Since the Global Financial Crisis (GFC), the Federal Reserve (Fed) has occasionally used its annual Jackson Hole symposium to preview changes in monetary policy. Over the last two months, financial markets began to anticipate Chair Jerome Powell would address the Fed’s dual mandate of full employment and price stability during his speech on August 27 (the meeting was held virtually this year due to COVID-19). In particular, the market appeared to expect a willingness by the Fed to allow inflation to overshoot its long-term 2% target, as we’ve witnessed a recent steepening in both the inflation breakeven and nominal yield curves (Charts 1, 2).

Chart 1

5-Year, 5-Year Forward Breakeven Inflation Rate

    Data from 12/31/19 to 08/28/20. Source: Bloomberg L.P., PNC Capital Advisors

Chart 2

Spread Between 2-Year US Treasury Note and 30-Year US Treasury Bond

     Data from 12/31/19 to 08/28/20. Source: Bloomberg L.P., PNC Capital Advisors

As expected, Chair Powell outlined several updates to the Fed’s framework, which was informed by both its internal research and a series of Fed Listens events around the country (the Fed Listens events were aimed at broadening the Fed’s perspective and engaging the public “as is appropriate in our democratic society”). This work led the Federal Open Market Committee (FOMC) to codify changes through unanimous approval of a revised “Statement on Longer-Run Goals and Monetary Policy Strategy.”1 Notable changes to the framework include the following:

  • With respect to employment, the FOMC emphasized a broad-based and inclusive goal that assesses “shortfalls of employment from its maximum level.” Previously, the focus was on “deviations from its maximum level.”
  • Regarding price stability, the FOMC moved towards a symmetric goal targeting longer-run inflation of 2% by seeking “to achieve inflation that averages 2% over time.”

This updated framework is a reflection of the low interest rate environment, both domestically and globally that has persisted since the GFC. By implementing these changes, we believe the FOMC is acknowledging that reliance on the traditional policy tool – the fed funds rate – will likely be constrained. While this suggests the fed funds target range will remain at or near the effective lower bound for an extended period, the announcement has helped alleviate market pressure that resulted from speculation about the possibility of negative rates in late 2021/early 2022 (Chart 3).

Chart 3

Fed Funds Futures Curve (Rate)

    As of 08/28/20. Source: Bloomberg L.P., PNC Capital Advisors

Most importantly, in our view, is the impact of the subtle shift in the employment mandate, which brings into the Fed’s calculus many of the socioeconomic imbalances that have been cast in stark relief by the pandemic. As Chair Powell outlined in his speech, the “change reflects our appreciation for the benefits of a strong labor market, particularly for many in low- and moderate-income communities.” Indeed research from the Pew Research Center earlier this year indicates a widening gap between upper-income households’ share of aggregate income (approaching 50%) and middle/lower-income households. Wealth concentration is even more pronounced, with upper-income households accounting for almost four-fifths of the US aggregate.2 We expect the Minneapolis Fed’s Opportunity and Inclusive Growth Institute, established in early 2017, will continue to be instrumental in supporting the broader Fed’s efforts through its research focused on supporting “economic opportunity and inclusive growth for all Americans.” We hope this will be an important step down a long path to address the economic and wealth disadvantages prevalent across the United States, in part attributable to systemic racism.

Market Implications

It is clear the Fed stands ready to support the economy through both traditional and unconventional policy tools for the foreseeable future. Since the GFC, macro and structural issues have created persistent headwinds for the Fed’s efforts to achieve its inflation objective on a consistent basis. While these headwinds are unlikely to abate, we expect the announced policy changes should – all else equal – result in a steeper yield curve, higher inflation expectations (as measured by Treasury Inflation Protected Securities breakeven spreads), and a lower US dollar, supporting investor risk appetites. While well off its peaks, the global balance of negative yielding debt still approximates $14 trillion and likely limits the potential for US interest rates to rise materially despite a more dovish Federal Reserve – much to the dismay of the bond vigilantes of yore.

1 – “Statement on Longer-Run Goals and Monetary Policy Strategy.” Federal Reserve (August 27, 2020). https://www.federalreserve.gov/monetarypolicy/reviewof-monetary-policy-strategy-tools-and-communications-statement-on-longer-run-goals-monetary-policy-strategy.htm

2 – “Trends in U.S. Income and Wealth Inequality.” Pew Research Center, Washington D.C. (January 9, 2020). https://www.pewsocialtrends.org/2020/01/09/ trends-in-income-and-wealth-inequality/

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.

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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.

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