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
Following its unprecedented monetary policy actions during the first half of the year, the Fed continued to reinforce its accommodative stance throughout the third quarter. As we discussed in a recent commentary, the Fed provided an updated framework outlining how it intends to assess the dual mandate of full employment and price stability in seeking the appropriate policy response. The Fed appears to be taking a more holistic approach to measuring full employment by using a more inclusive method of seeking maximum employment beyond an explicit unemployment rate. We believe this suggests a willingness to be very patient as the labor market continues to recover. Regarding price stability, the Fed stated a desire to target an average level of inflation of 2% over time. This updated view will allow a tolerance for inflation to exceed 2%, possibly for a lengthy period of time, given the persistent shortfall in inflation in the years following the Global Financial Crisis.
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
Important Disclosures
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.
- Corporate credit has the potential to provide important sector allocation opportunities to produce alpha in client portfolios.
- Given the more pronounced idiosyncratic risk, it is important to maintain both a well-diversified portfolio and a disciplined research process, as demonstrated by our fundamental, team-based approach.
- High-quality, low-risk premium portions of the market exhibit greater consistency in the context of our historical analysis. As a result, we believe that more persistent allocations to this segment provide the potential to enhance portfolio returns.
- Selective and opportunistic investing in lower-quality and longer-maturity credit securities can play a role in maximizing excess return of the overall portfolio.
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.
