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Related Insight

Quarterly Perspectives 1Q21

First Quarter Highlights

  • The economic growth outlook for 2021 has significantly improved due to additional fiscal stimulus and an expanded vaccine distribution effort.
  • Recent economic statistics support the “V-shaped” recovery narrative, with particularly strong trends in the manufacturing and housing sectors.
  • The Federal Reserve (Fed) remains steadfast in its commitment to accommodative policy as it plans to continue the current pace of asset purchases until employment and inflation measures progress towards long-term objectives.
  • Following successful passage of the $1.9 trillion stimulus bill, the Biden administration has proposed an infrastructure spending plan along with a proposal to increase corporate tax rates
  • U.S. Treasury (UST) yields, particularly longer-dated maturities, have reacted to the increased federal spending and improving economic outlook by moving higher, resulting in the steepest yield curve in more than five years.
  • Credit spreads continued to compress in the first quarter, with longer-duration and lower-quality issuers performing best.
  • Volatility was generally confined to the UST market as increased reflationary prospects were priced into expectations, combined with several weak UST note auctions.

Duration Positioning

Neutral
Continue to maintain a benchmark-like duration stance across strategies.

Credit Sector

Overweight
Overweight financials and select industrial sectors, primarily within energy, technology and telecom. Given expensive valuations in short-duration credit, we have extended maturity profiles to optimize exposures where credit curves are steepest.

Structured Products

Neutral in Aggregate strategies, Overweight in short duration strategies
Modestly reduced overweight’s in Asset-Backed securities while adding to Agency Mortgage-Backed Security allocations.

Sector Review

Investor optimism drove financial markets during the first quarter once it became clear than an economic recovery was successfully picking up steam. Accelerated vaccine distribution coupled with additional fiscal stimulus has led to lofty economic growth projections for the balance of 2021. Recent economic statistics (particularly from the manufacturing and housing sectors) support confidence in the outlook (Chart 1). Given this backdrop, markets have continued to build on the reflationary theme from the prior quarter, as intermediate- and long-dated UST yields moved substantially higher and the curve steepened. Accordingly, the Bloomberg Barclays Aggregate Index realized a negative total return of 3.37% for the quarter. Excess returns were positive for all primary investment-grade sectors, but at only 35 basis points (bps), it did little to counteract the impact of the UST curve bear steepening (Table 1). While spreads were generally tighter across sectors by the end of March, many sectors struggled to find footing during the quarter as volatility in rates markets developed in the second half of February.

Table 1
Sector Comparison

sector-table

As of 3/31/21. Source: Bloomberg Barclays

Policy Combo Unlocks Market Risk Appetite...Again

Consistent with its messaging throughout the COVID-19 pandemic, the Fed reaffirmed its decidedly accommodative stance at the latest Federal Open Market Committee (FOMC) meeting despite growing expectations for a robust V-shaped recovery. While FOMC members revised their economic projections substantially higher, they left the central tendency of the forecasted policy rate unchanged at 0 – 25 bps through 2023.

The Fed’s commitment to ensuring a sustained, broad-based recovery remains paramount, in our view. Fed members continue to stress that large swaths of the economy and labor force remain under stress and at risk of being left behind. In line with this objective, the Fed has maintained the current pace of its $120 billion monthly purchases of UST and mortgage-backed securities and has indicated that it will continue to do so for the foreseeable future.
Chart 1
The ISM Index is at its highest level in decades
ISM Index Chart

As of 3/31/21. Source: Bloomberg L.P.

Should the recovery proceed as briskly as expected over the balance of 2021, investors will be increasingly mindful of a possible shift towards tapering secondary market activity. This could ultimately presage a subsequent increase in the fed funds target rate. For now, the Fed has largely deferred from offering any clear details on its thought process but has indicated it will provide markets with plenty of advance notice. While changes to its balance sheet strategy may not occur this year, the Fed will need to proceed deliberately and communicate effectively to avoid a “tantrum” like we saw in 2013.
Chart 2
The 2/10 curve is the steepest its been since 2015
curve-chart

As of 3/31/21. Source: Bloomberg L.P.

Fiscal policy had a substantial impact on financial markets during the quarter as the new administration capitalized on the slim democratic majority in Congress to pass another sizeable round of stimulus. Expectations for GDP growth this year have risen accordingly. Equity and credit markets remain well supported by government spending, and upward pressure on intermediate- and long-term UST rates accelerated. The 2/10 curve steepened to over 150 bps in late March, a level not seen since mid-2015 (Chart 2). The Biden administration is looking to continue implementing bold policy initiatives, introducing a broad infrastructure plan along with proposed changes to corporate tax policy. Right now, a bipartisan deal seems unlikely and there are notable differences within factions of the democratic party. The fiscal policy response is undoubtedly taking pressure off the Fed and allowing it flexibility to see how the recovery develops before initiating additional actions.

A Little Inflation Up in Here, Up in Here

Opportunity Buds from Volatility

Corporate issuers were eager to secure funding or refinance existing debt before potential further yield increases, which led to considerable new-issue supply, consistent with the record pace seen in 2020. Investor demand was largely able to absorb this issuance, but there were moments where market indigestion was evident (e.g., wider pricing concessions and/or instances of new debt trading sluggishly in the secondary market). Off-the-run securities were impacted by the rapid yield steepening, leading to wider spreads relative to the nearest maturity UST security. This presented us with opportunities to optimize our positioning by adding to those portions of the market where spreads widened and curves steepened, creating the potential for improved total return dynamics for client portfolios as these securities roll down the curve over time.
Chart 3
Rising MBS rates have slowed refinancings and extended the duration of the MBS sector
rising-mbs-chart

As of 3/31/21. Source: Bloomberg L.P.

Similarly, the MBS market was shaken by the surge in UST yields. Prepayment assumptions slowed due to higher mortgage rates, and related selling amplified the yield move as the duration of the Bloomberg Barclays US Mortgage-Backed Securities Index roughly doubled over the last couple of months. The Fed’s commitment to ongoing purchases helped the market stabilize; however, with elevated new MBS supply, investors remain somewhat skittish of renewed rate volatility. Alternatively, higher rates have led to a slower pace of refinancing activity, which provides a more favorable backdrop moving forward. Given these competing factors, we remain neutral in MBS in our aggregate strategies. In non-aggregate strategies, where our MBS allocations are overweight, we continue to emphasize defensive 10- and 15-year passthrough securities that have a more favorable convexity profile in an environment with heightened extension risk.
We believe similar scenarios are likely to persist when interest rate volatility is elevated, which could be a routine event given the outsized influence policymakers have in markets and the potential for any pivots in their respective strategies. While we firmly believe monetary and fiscal support will remain in place, markets will continue to be sensitive to surprises given the high levels of optimism regarding the near-term outlook, both domestically and globally. Over the last several months, riskier assets have shown tremendous resiliency and have largely shrugged off unexpected developments given the overwhelmingly positive technicals across financial markets. Given the lofty valuations of many asset classes, we feel prudence is warranted during times like these. However, our long-term perspective affords us the flexibility to act quickly to adjust portfolio allocations as opportunities arise.

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 there with.
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. serving institutional clients. 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.

©2021 The PNC Financial Services Group, Inc. All rights reserved.

FOR INSTITUTIONAL USE ONLY

INVESTMENTS: NOT FDIC INSURED-NO BANK GUARANTEE – MAY LOSE VALUE

  • 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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