Second Quarter Highlights
The economic recovery continued to gain momentum despite supply chain challenges that have restricted the availability of a variety of input goods, leading to commodity price pressures.
After a weaker-than-expected April payroll report, labor markets improved at a brisk pace in May and June. While labor shortages persist, there have been signs of improvement in virus-sensitive sectors.
Both headline and core inflation data surged to levels not seen for decades. Financial markets have generally dismissed these increases as short-lived and largely influenced by supply chain issues and 2020 base effects.
The Federal Reserve (Fed) responded to the improving economic backdrop at the June Federal Open Market Committee (FOMC) meeting with a more optimistic tone, pulling forward projections of possible rate hikes to 2023.
The Fed’s asset purchase strategy remains unchanged for now, but discussions about tapering the pace of purchases was discussed at the June meeting and will be an item of focus at upcoming meetings.
The U.S. Treasury (UST) yield curve flattened rather abruptly during the latter stages of the second quarter as longer-term expectations for both inflation and growth faded
Credit risk premiums continued to compress with minimal volatility as investor demand for incremental yield supported lower-quality issuers.
Maintaining a benchmark-like duration stance across strategies.
Overweight Financials and select Industrial sectors, primarily within Energy, Information Technology and Communication Services. Reduced allocations in high-quality credit due to unattractive valuations.
Spreads continued to tighten across sectors
Monetary Policy: Connecting the Dots
Median projections now indicate two rate hikes in 2023
Curve-Steepening Trade Flattened
The breakeven spread on 10-year TIPS retreated from
near-term highs as the yield curve flattened
Portfolio Positioning: Focus on Tactical as Relative Value Scarce
The Consumer Price Index (CPI) is a measure of the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services.
The Personal Consumption Expenditures Price (PCE) Index reflects changes in the prices of goods and services purchased by consumers in the United States. Quarterly and annual data are included in the Gross Domestic Product (GDP) release.
The Bloomberg Barclays US 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).
Past performance is no guarantee of future results.
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INVESTMENTS: NOT FDIC INSURED-NO BANK GUARANTEE – MAY LOSE VALUE
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.