In Bonds, No One Can Hear You Scream: The Sequel
“In Bonds, No One Can Hear You Scream,” was an article I penned in the 3rd quarter of 2016. It was about low rates and the dilemma bond investors face investing in this asset class. Four years later, the same discussion is taking place. The Fed has promised to keep rates low through 2023, and so the conundrum to investors continues. Here is how the third quarter 2020 unfolded:
Q3 in the Taxable Blond portfolio started off with a strong July, followed by a slight re-trace of yields in August and a step backwards in September as investors braced for the possibility of a volatile fall in equity markets. Overall, the Bloomberg Barclays US Aggregate Bond Index returned 0.57% for Q3 and the Bloomberg Barclays Intermediate Corporate Total Return Index was up 1.33%.
Investment grade supply and liquidity were the themes for the quarter. September 2020 investment grade supply came in at $174 billion, a record for the month of September. September 2020 ended the busiest Q3 of investment grade supply on record at $387 billion. Supply is running up 66% on a year-over-year basis. The growth in supply was met with relative calm in the markets as the ICE BofA Move Index made a new yearly low on September 29th, showing relative calm in the markets.
The week of September 25th was the worst week for high yield since March 2020, when the Bloomberg Barclays U.S. Corporate High Yield Index finally seemed to have a buyer strike. However, this proved to be just a little hiccup for the market as the Index edged higher moving into quarter end. For high yield issuers, it is positive that the economy is recovering from the COVID-19 lockdown and that the Fed has promised to keep rates pinned near zero into 2023. This is reflected in a statement from Moody’s Investors Service, which says that the U.S. corporate default rate fell from 3.8% at mid-year to 3.3% in September.
Negative macro news piled up by quarter end. Hopes of a second stimulus package seemed to be fading with the summer sun. The passing of Ruth Bader Ginsburg creating a new appointment for SCOTUS. Despite the initial bluster, there is very little the Democrats can do to block an appointment by the Republican held Senate. COVID cases appear to be ticking up in Europe and new hot spots in the U.S. as the flu season approaches.
All of this seemed to weigh on the market, causing stocks, as reference by the S&P 500, to lose 3.80%, followed by the Bloomberg Barclays US Corporate High Yield Bond Index dropping 1.04% and the Bloomberg Barclays Intermediate Corporate Total Return Index declining by 0.18%.
With these macro events taking place, we are subtly shifting the portfolio’s weightings after years of promoting a barbell strategy. We have moved out the curve and are buying very little 1-year paper. As a result, the portfolio is structured a bit more bell shaped, with some additions to the investment grade space in 7-10-year bonds. We continue to find short call high yield bonds attractive. We have had some BB credits called at the make whole call level, which is usually attributed to investment grade corporations. Rates at these historically low levels have enabled many high yield companies to refinance and extend bond maturities out to 7-10 years.
The yield curve remained static in the quarter. 2-year Treasury bonds rallied from 15 basis points to 12.9 basis points and 10-year bonds rose slightly. Beginning the quarter at 0.657%, the market rallied and hit a new low on August 4th of 0.508%. From August 4th, the 10-year sold off and closed at 0.685%. Not really much to talk about overall, but for the quarter, the 2-10-year Treasury curve steepened a couple a couple of basis points. Overall, this was not a dramatic shift to affect the Taxable Fixed Income strategy.
From a sector perspective, our themes have been Housing, Technology, and areas of the market we feel could benefit from a stimulus bill and separately from an infrastructure bill. If the unemployment rate cannot move back to the pre-COVID levels of 3%, we believe there would probably be more pressure for an infrastructure package from both parties. We mostly avoided Banking and Finance sector names during the quarter, but did find a few names where spreads slightly widened and valuations seemed more attractive by quarter end.
Macro risks are still present, but we will stay the course with our disciplined investment approach. We will look to provide current income, credit protection, and diversified security selection in our portfolio implementation process.
In fixed income, we refer to almost all purchases at the time of the buy as having “relative value”. With the Fed suppressing volatility and keeping rates low, we need to look at each purchase as having relative “relative value”. I am not sure if that is a double negative or a double positive. As an active manager, we believe increased volatility and higher rates are an opportunity in the fixed income market. However, at the moment, it seems that the Fed has other plans.