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Related Insight

Quarterly Perspectives 2Q21

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.

Duration Positioning

Neutral
Maintaining a benchmark-like duration stance across strategies.

Credit Sector

Overweight
Overweight Financials and select Industrial sectors, primarily within Energy, Information Technology and Communication Services. Reduced allocations in high-quality credit due to unattractive valuations.

Structured Products

Neutral in aggregate strategies; Overweight in short duration strategies Maintained overweights in Asset-Backed securities and modestly reduced weights in Agency Mortgage-Backed Security (MBS) allocations.

Sector Review

The reflationary narrative that dominated the early months of the year lost some momentum during the second quarter as a number of market indicators reinforced the Fed’s view that the recent surge in inflation is likely transitory. Meanwhile, the outlook for strong economic growth continues to be well supported but does face some headwinds from a shortage of a variety of input materials as well as a persistent scarcity of labor. Together these factors contributed to a noticeable flattening of the yield curve, reversing the persistent steepening trend of the prior two quarters. Consequently, the Bloomberg Barclays Aggregate Index realized a total return of 1.83% for the quarter, erasing roughly half of the negative first quarter return. Investment grade excess returns were positive during the quarter as credit spreads continued to narrow (Figure 1). However, agency MBS came under pressure and was the one sector to produce negative excess returns. Lower quality credit continued to outperform as high yield spreads tightened to new post-Global Financial Crisis lows.
Figure 1. Sector Comparison
Spreads continued to tighten across sectors
Figure 1_Sector Comparison
As of 6/30/21. Source: Bloomberg Barclays

Monetary Policy: Connecting the Dots

Faced with mounting evidence of an accelerating economic recovery, the Fed took a moderately hawkish pivot at the June FOMC meeting. This turn in sentiment helped alleviate concerns that the Fed might leave its extremely accommodative policy on auto pilot longer than warranted and risk overstimulating the economy. While the Fed raised its economic projections only modestly from March, FOMC members’ median interest rate forecast for 2023 now indicates two hikes, up from zero in the prior quarter (Figure 2). Additionally, Fed Chair Jerome Powell indicated the committee had begun talking about tapering asset purchases, with the caveat that actual implementation would likely still be a ways off. Although, minutes from the June meeting suggest a lack of consensus about timing, the evolution of Fed commentary in recent months suggests the program could begin winding down by first quarter 2022. Furthermore, the Fed has been very clear it has every intention of giving markets plenty of advance notice as it looks to carefully reduce the pace of UST and MBS purchases with the least amount of disruption. There has also been quite a bit of speculation among fixed income investors as to whether the Fed would begin reducing MBS purchases given the strength in the housing market. Fed minutes suggest this is an area of ongoing debate. We continue to believe an official announcement on the Fed’s tapering strategy will likely come later this year with an effective date shortly thereafter.
There were other Fed actions during the quarter that didn’t receive the same degree of focus as the dot plot and taper talk but were significant, nonetheless. At the June meeting, the FOMC raised the overnight reverse repo rate as well as the rate paid on excess reserves by 5 basis points (bps), to 5 and 15 bps, respectively. This brought welcome relief to money market and short duration investors who have been dealing with a flood of cash into short-term funding markets. Use of the Fed’s reverse repo facility has been surging in recent weeks, spiking to just under $1 trillion at quarter end. The Fed’s actions helped raise the floor a few basis points above 0.00% for the shortest government assets, but there continues to be a lack of supply to satisfy the tremendous amount of cash in money markets.
The other noticeable announcement came a couple weeks ahead of the June FOMC meeting when the Fed announced the wind-down of the Secondary Market Corporate Credit Facility. This program, which was announced at the height of the March 2020 market dislocation, proved tremendously successful in stabilizing investor nerves despite its modest use. At the time of the wind-down announcement, the Fed held approximately $13.5 billion in front-end corporate bonds and exchange-traded funds. Given the relative size of the facility and continued strong investor demand, the market took the announcement in stride. Investors will likely expect a similar rescue in future panics, a precedent that future Fed chairs will have to navigate.
Figure 2. FOMC Implied Fed Funds Target Rate Projections
Median projections now indicate two rate hikes in 2023
As of 6/30/21. Source: U.S. Federal Reserve, PNC Capital Advisors

Curve-Steepening Trade Flattened

Figure 3. 10-Year TIPS Breakeven Rate vs. 10-year – 2-year UST Yield Curve
The breakeven spread on 10-year TIPS retreated from
near-term highs as the yield curve flattened
As of 6/30/21. Source: Bloomberg L.P.

Portfolio Positioning: Focus on Tactical as Relative Value Scarce

In structured products, we maintained an underweight to Agency MBS in aggregate strategies, which benefited relative performance as mortgages continue to lag other investment-grade sectors. Potential volatility in the sector associated with the Fed’s eventual taper may present an opportunity to add to mortgages later in 2021. In short duration strategies, we continue to hold an overweight in defensive 10-year and 15-year pools but have modestly reduced the allocation. Elsewhere in the securitized markets we have maintained weights in consumer asset-backed securities through the modestly active new issue market. Despite expensive valuations, we have seen relative value in the sector compared to other high-quality front-end alternatives.
In core and intermediate strategies, we initiated a position in shorter-maturity TIPS as valuations improved and provided an attractive entry point. In our view, this was an opportunity to capture excess return given supply chain and labor shortages. We also expect a positive carry profile in the summer months due to an expected continuation of strong monthly headline CPI prints. While April and May CPI were led by the rebound in airfare, hotel and used car prices, factors such as housing and energy should keep CPI elevated in the near term.
Heading into the third quarter, we aim to maintain flexibility in client portfolios to accommodate increased risk exposure should market volatility lead to compelling investment opportunities. Given strong market technicals and relatively expensive valuations across credit, we believe issuer and security selection are paramount. As our experience from numerous recent periods of prolonged low volatility has taught us, a placid market environment can be quickly disrupted by shifting monetary policy agendas.

Indices

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).

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.

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