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Related Insight

Quarterly Perspectives 1Q20

First Quarter High(Low)lights
  • During the quarter, the emergence of COVID-19 in the US sparked record-setting market volatility across asset classes, prompting unprecedented fiscal and monetary policy responses intended to combat the emerging economic and financial fallout from the pandemic.
  • Credit markets deteriorated significantly, with spreads widening to levels last seen during the financial crisis. Likewise, the US Treasury yield curve fell dramatically during the first quarter, as global investors sought liquid, high-quality assets.
  • Economic data weakened precipitously in the final days of the quarter, as the impact of various global lockdowns and changing consumer behaviors began to emerge in reported statistics.
  • The Federal Reserve (Fed) responded with a battery of measures intended to ease financial conditions and improve market liquidity and overall functioning.
  • Following the Fed’s intervention, as well as unprecedented fiscal support from Congress, fixed income market conditions improved towards the end of the quarter.
  • We expect continued volatility in the foreseeable future, as developments related to COVID-19 continue to unfold.
Duration Positioning
Neutral
Maintaining a benchmark-like duration stance across strategies, with a modest underweight to the front end of the curve.
Credit Sector
Modestly Overweight: Adding to higher- quality issues in longer-maturity strategies
Overweight Financials and select BBB Industrials; focused in maturities less than 5 years. Increased allocations in high-quality, defensive sectors given dramatically improved valuations.
Structured Product
Overweight
Maintained overweights in Asset-Backed and Agency Mortgage-Backed Security allocations.
First Quarter Sector Review

The healthy backdrop for financial markets at the start of the year deteriorated rapidly in March, as global cases of the novel coronavirus (COVID-19) surged, quashing any optimism surrounding the effective containment of the spread. Volatility surged, as many segments of the fixed income market suddenly failed to function properly due to an abrupt decline in liquidity. Recognizing the immediate threats this posed to the financial system, the Fed moved decisively to enact bold policy decisions to facilitate market liquidity, attempting to ensure markets could function properly during this time of rapid re-pricing. 

As the pandemic sparked a sudden, global flight to quality across financial markets, investors sought refuge in the US dollar and US Treasuries. Treasury yields collapsed, 

Bloomberg Barclays Aggregate Bond Index

Sector
Duration (Mod. Adjusted)
Option-Adjusted Spread (OAS) (bps)
OAS Change Quarter-over-Quarter
Excess Returns: 3 Months
U.S. Agency
3.93
49.0
39.0
(1.06)
U.S. Credit
Industrial
Utility
Financial Institutions
Non-Corporate Investment Grade
7.68
8.67
10.57
6.07
6.10
255.0
276.0
254.0
268.0
164.0
165.0
177.0
157.0
158.0
92.0
(12.72)
(14.84)
(15.40)
(10.46)
(8.58)
U.S. Mortgage Backed Securities
1.67
60.0
21.0
(0.83)
Asset-Backed Securities
2.07
213.0
169.0
(3.22)
CMBS: Erisa Eligible
5.31
188.0
116.0
(5.86)
U.S. Corporate High Yield
4.06
880.0
544.0
(17.03)

Source: Bloomberg Barclays
See Important Disclosures at the end of this document for additional information.

with most portions of the curve registering all-time low yields, highlighted by the 30-year bond briefly trading below 1%. As a result, the Bloomberg Barclays Aggregate Index produced a positive total return of 3.15% during the quarter, despite the immensely negative excess returns across most spread sectors. US Credit produced -12.72% of excess return during the period, as the option-adjusted spread (OAS) of the Bloomberg Barclays US Aggregate Credit Index surged by 165 bps. High-yield markets unsurprisingly plummeted as well, with first quarter excess return of -17.03% for the Bloomberg Barclays US Corporate High Yield Index, translating to a total return of -12.68%. High-quality structured products fared significantly better, as the Mortgage-Backed and Asset-Backed sectors produced excess returns of -83 bps and -322 bps, respectively, during the first quarter.
As striking as these negative excess returns were for both investment-grade and high-yield credit, they are significantly better than the levels witnessed on March 23, when spreads for both sectors peaked at 341 bps and 1,100 bps, respectively. The rapid improvement in spreads during the last week of March was largely associated with the timing of substantial monetary and fiscal policy responses. Because events are still unfolding, the duration and extent of the current downturn remains uncertain. This will likely result in elevated volatility for the foreseeable future.
Monetary Policy: Keep On Using Me…’Til You Use Me Up
A continuation of solid economic data to start the year suggested the Fed would be able to successfully move to the sidelines after cutting the policy rate three times in the second half of 2019. While Fed Chairman Powell set a cautiously optimistic tone following the Federal Open Market Committee’s January 29 meeting, the script quickly flipped, as the pandemic stoked investor fears about the depth and breadth of a global economic slowdown. As market volatility escalated, the Fed moved swiftly and decisively in two intra-meeting policy announcements on March 3 and 15. This resulted in a return to zero interest rate policy, with a cumulative 150 bps reduction in the fed funds target rate to a range of 0-25 bps. Concurrently with this traditional policy easing, the FOMC responded with increasingly aggressive measures to stabilize financial markets, including:
  • Extending swap lines to global central banks to ease funding stress for US dollars.
  • Lowering the discount window rate to 25 bps and encouraging banks to utilize borrowing capacity to extend credit.
  • Expanding repo facilities from last fall to improve liquidity in the US Treasury market.
  • Restarting quantitative easing, with expanded purchases of US Treasury and Agency MBS securities at “the amounts needed to support the smooth market functioning”.
  • PDCF (Primary Dealer Credit Facility): Mechanism to support funding securities inventories on broker/dealer balance sheets.
  • CPFF (Commercial Paper Funding Facility): Supports the short-term borrowing needs of top-tier (A-1/P-1) commercial paper issuers.
  • MMLF (Money Market Liquidity Facility): Provides liquidity to prime money market funds experiencing significant outflow.
  • TALF (Term Asset Liquidity Facility): Mechanism to fund purchases of high-quality, new issue asset-backed securities.
Bloomberg Barclays US Aggregate Credit Index* Average OAS(bps)
*Shaded area indicates first quarter 2020 As of March 31, 2020. Source: Bloomberg Barclays

Federal Reserve Total Assets ($ in trillions)

As of March 31, 2020. Source: The Federal Reserve (www.federalreserve.gov/ monetarypolicy), PNC Capital Advisors analysis
While the latter two programs have not launched, the cumulative effect of the measures taken so far has been largely effective in alleviating the building stresses seen across money markets and the US Treasury/Agency MBS market. As a result, the Fed’s balance sheet has expanded dramatically to $5.8 trillion.
The corporate bond market became significantly dislocated by mid-March, as outflows from investment grade funds (tallied by the Investment Company Institute), crested above $25 billion for two consecutive weeks.
Many fixed income exchange-traded funds were under considerable pressure and traded at discounts to underlying net asset values, prompting the Fed to take unprecedented action to keep the market functioning given the supply/demand imbalance. With equity infusions from the US Treasury Department, the Fed announced the formation of both the Primary Market and Secondary Market Corporate Credit Facilities, with the latter targeting purchases of up to 20% of individual ETFs. While these facilities have yet to launch, the announcement on March 23 coincided with near-term peak spreads in both investment-grade and high-yield securities. The Fed’s bold moves helped alleviate stress in the corporate market and drive a normalization of the Credit OAS curve.

By the end of the quarter, an improved tone was evident across the corporate new issue market, where supply has surged and investor demand has returned. New issue markets provided price transparency for investors challenged by the dislocations in the secondary market. Swelling issuance in the second half of March produced record monthly and quarterly supply, the latter approaching almost $500 billion. The calendar was dominated by domestic, non-financial companies and skewed towards higher-quality issuers, with approximately two-thirds rated single A or higher, which likely reflected issuers that were accustomed to accessing commercial paper markets for ongoing funding. Pricing on these deals came at very attractive levels, consistent with where BB-rated high-yield debt had been valued just months earlier! The breadth of issuers expanded recently to include both lower-quality BBB and selective cases of high yield. Credit markets are slowly beginning to function more normally, aided by improved risk appetites and early signs of potential success in “flattening the curve” of new COVID-19 cases.

ICI Total Bond Estimated Weekly Net New Cash Flow ($ in billions)

As of March 31, 2020. Source: Bloomberg L.P.
Outlook: Economic Data is U-G-L-Y, but It’s Got an Alibi
Over the last month, investors have had to navigate a daily onslaught of bad news knowing negative consequences for near-term economic and financial activity is inevitable. A meteoric rise in jobless claims during the last two weeks epitomizes the immediate and devastating impact the COVID-19 outbreak will have on the domestic economy. The sizeable fiscal package rushed through Congress and the multitude of programs announced by the Fed should provide some ballast to the economy, but a severe economic contraction is now unavoidable. Great uncertainty remains on both the depth and duration of this contraction as well as the pace of the eventual recovery, as there are currently too many unknowns to inform any sort of specificity on an investment outlook with strong conviction.

Despite the high level of uncertainty about how future developments will impact markets, we have identified many attractive investment opportunities over the last month. We believe it’s important to emphasize that many of these opportunities exist due to the defensive moves we made in client portfolios over the preceding months. As discussed in recent quarterly commentaries, valuations in credit had become increasingly unattractive towards the end of 2019. We reduced allocations in corporate credit across strategies, favoring AAA-rated structured securities or increased Treasury weightings instead. While the fundamental backdrop (at the time) was still very healthy, the compensation to take risk was insufficient for doing so. As corporate credit spreads repriced dramatically wider during March, we capitalized by taking advantage of the dislocations in short-dated markets by purchasing high-quality bonds that were being indiscriminately sold by asset managers scrambling to meet client outflows. These massive outflows, coupled with a lack of liquidity in markets, led to instances of high-quality debt trading at deeply distressed levels. In longer-dated strategies, the new-issue market provided excellent opportunities to selectively add exposure to highly rated companies in defensive industries, with ample balance sheet flexibility, and at attractive spreads.

Bloomberg Barclays US Credit 1-3 Year Index Average OAS vs. Bloomberg Barclays US Aggregate Credit Index Average OAS
As of March 31, 2020. Source: Bloomberg Barclays
Cyclical sectors related to discretionary consumer spending, including autos, travel, lodging, and leisure are likely to suffer long-term structural effects and significant downgrades by the rating agencies (see our recent commentary, “Rapidly Shifting Tides in the Economic and Credit Cycle ”). The energy sector will likely remain stressed as it continues to suffer from the one-two punch from a COVID-19 demand shock and a supply glut driven by a price war between Saudi Arabia and Russia. Early damage among Energy companies was quickly seen in terms of relative performance and rating downgrades, particularly in highly levered entities that cannot profitably operate with crude prices anywhere near current levels.
The longer the current predicament plays out, we believe the odds increase that additional sectors will see their business models become increasingly tenuous. For this reason, any additional risk exposure we add in portfolios will be thoughtful and cautious, consistent with our risk-focused process. Volatility and challenging liquidity conditions should be expected to continue given the substantial challenges the global economy faces in the coming months. While we believe this environment will continue to present attractive investment opportunities, our primary goal remains to preserve our clients’ capital by maintaining high-quality, liquid portfolios.
Indexes
The Bloomberg Barclays U.S. Aggregate Bond Index is a broad-based benchmark that measures the investment grade, U.S. dollar-denominated, fixed-rate taxable bond market. The index includes Treasuries, government-related and corporate securities, MBS (agency fixed-rate and hybrid ARM pass-throughs), ABS and CMBS (agency and nonagency).

The Bloomberg Barclays U.S. Aggregate Corporate Index represents the total return measure of the corporates portion of the Barclays U.S. Aggregate Index.

The Bloomberg Barclays U.S. High Yield Index covers the universe of fixed rate, non-investment grade debt. Canadian and SEC-registered global bonds of issuers in non-emerging countries are included. The index includes both corporate and non-corporate sectors.
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 by the author 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®). To receive a list of composite descriptions of PNC Capital Advisors, LLC and/or a presentation that complies with the GIPS® standards, please send an email to Compliance at [email protected].


PNC Capital Advisors, LLC is an SEC-registered investment adviser, offering an array of investment strategies. 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 Advisor’s 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.

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