Third Quarter Highlights
- Economic indicators continued to strengthen, although the pace of improvement slowed in September.
- Credit spreads also improved; however much of the tightening came in July, as spreads drifted wider from mid-August through the end of September.
- The Federal Reserve (Fed) remained decidedly dovish, highlighted by an updated policy framework and a new series of economic projections, both of which portend extraordinarily accommodativepolicy for the foreseeable future.
- Fed actions have led to an increase in inflation expectations as well as a steeper yield curve.
- Volatility measures remain in check, with interest rate volatility at record lows. The markets are bracing for the US presidential election as a source of potential instability.
- Gridlock in Washington has made additional fiscal support elusive despite general agreement that it remains necessary for a sustained recovery.
Somebody Get Me a Doctor!
Paying tribute to the late Eddie Van Halen, we have to look no further than his namesake’s band’s song titles for an apropos description of the quarter. While Everybody Wants Some additional fiscal stimulus and the Fed has implored Congress to Finish What Ya Started, the hypercharged political environment combined with the upcoming presidential election has left negotiations D.O.A. (dead on arrival) for the time being. We remain optimistic that when Push Comes to Shove, it will not be a question of whether there is additional stimulus but rather the scale of any new round of support. The Eruption in corporate supply during 2020 was supported by conditions that issuers viewed as the Best of Both Worlds: strong demand technicals that led to tighter spreads, as well as record-low all-in yields. However, this has led to greater market risks as the concentration in BBB-rated bonds has increased and maturity profiles have been extended. We are left wondering Where Have All the Good Times Gone as economic growth moderates, valuations become stretched, and a more pronounced second wave of COVID-19 cases begin to spread both domestically and globally. With concerns for additional volatility over the coming months, we are positioning client portfolios more defensively to Jump on opportunities that might develop.
Third Quarter Sector Review
A sense of normalcy returned to financial markets in the third quarter after an extraordinarily active and volatile first half of the year. The economy continued to benefit from the effects of tremendous fiscal and monetary support initiated in the spring, while constructive developments on COVID-19 treatments and vaccines supported risk appetites. Fixed income markets reacted favorably, with the Bloomberg Barclays Aggregate Index producing a positive total return of 0.62% for the quarter. Once again, the returns were largely generated by spread compression across most sectors, as excess returns totaled 0.46%. US Credit generated 1.36% in excess return during the period, as the option-adjusted spread (OAS) of the Bloomberg Barclays US Aggregate Credit index tightened by 14 basis points (bps). Lower-quality markets rallied as well, with the Bloomberg Barclays US Corporate High Yield Index generating an excess return of 4.37%. Excess returns on high-quality structured products were mixed in the quarter, as the Asset-Backed sector continued to be positive, while Agency Mortgage-backed securities were slightly negative for the quarter.
As of 09/30/2020. Source: Bloomberg Barclays
See Important Disclosures at the end of this document for additional information.
Certainty in an Uncertain World: The Fed Guides Lower for Longer
At the September Federal Open Market Committee (FOMC) meeting, the Fed elaborated on its new approach by providing additional details about its prerequisites for any increase in the fed funds rate. By committing to an outcome-based approach, we believe the Fed is indicating the current zero interest rate policy will be maintained for the foreseeable future. Consistent with this expectation, the FOMC’s new Summary of Economic Projections does not indicate any rate hikes through the end of 2023. Markets have generally been pricing in this expectation for some time, but as the Fed more concretely committed to this approach, inflation expectations responded by moving higher.
Pumping the Brakes as the Return-Risk Tradeoff is Foggy
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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.