High Grade Core Intermediate 1st Quarter 2014
Taxable High Grade Strategies
As the data to the right shows, our taxable High Grade Short Term, High Grade Core Intermediate and Government strategies all outperformed their benchmarks for the quarter. Our outperformance was driven by an overweight to spread sectors and a tilt towards a barbell curve posture, implemented in a strategy appropriate manner. Our investment process, which places our fundamental economic and credit outlook within a statistical rich/cheap valuation framework, led us to increase our exposure to corporates during the period, decrease our allocations to municipals, and eliminate our allocation to Treasury Inflation Protect Securities (TIPS).
The first quarter of 2014 was a case study in the diversification benefits of fixed income. As the charts below show, the first weeks of the year were a stark reminder that equity corrections still happen, and that bonds serve as an important counterweight to stocks. Bonds rallied, yields fell, and even Gold benefited from a change in investor sentiment that favored safe haven investing over “risk on” style investing. And, when risk assets recovered and fears about a future Fed tightening materialized later in the period, rates began to modestly rise.
In our most recent commentaries we noted that the economy was more likely on a muddle along trajectory than an accelerating growth trajectory. We also noted that while this modest level of growth supported our allocation to corporate bonds, and our outlook for tighter corporate spreads, that there were a variety of factors on the horizon that might challenge equity valuations, including the likelihood for investor asset reallocation. We noted in prior commentaries that the equity rally of 2013 had left many investors with an overweight to risk asset classes and that a rebalancing was inevitable that would favor fixed income1. Fixed income generated a healthy first quarter return and we believe that despite fears of rising rates, fully invested portfolios will materially outperform cash over the course of 2014.
Though tapering had been a concern in the summer of 2013, giving us the opportunity to purchase undervalued bonds, by the start of 2014 it was clear that tapering would not be aggressive, and the Fed would remain accommodative. This supported our overweight to corporate bonds and our allocations to other spread sector proxies such as municipals, Canadian provincials, and multilaterals. Our overweight to spread sectors, implemented in a consistent manner across our intermediate, short-term, and government strategies, made a significant contribution to our performance for the quarter. As the index data in Exhibit 1 shows, corporate bonds materially outperformed Treasuries.
In corporates, we have maintained a healthy allocation to financials. In this sector we look for banks that have lower exposure to mortgage lending, fixed income and commodities trading, and more exposure to traditional revenues generated by consumer and industrial loans. Our allocation to industrial bonds has stressed large annuity like businesses with highly visible cash flow, like pharmaceuticals, and corporations with product and geographic diversification to minimize operational risk. These broadly diversified corporations, the emphasis of our industrial approach, have strong balance sheet characteristics with largely predictable, defensive cash flow and transparent balance sheets. While there may be security specific exceptions to these investment themes, this approach broadly explains our current positioning.
Municipals, which richened for much of the quarter (as can be seen in Exhibit 3), also outperformed Treasuries. As ratios richened we reduced our exposure to the sector across our taxable high grade strategies. We expect ratios on tax-exempt securities to be richer in the period ahead of us as municipal officials shift their issuance from shorter to longer maturities to lock in low yields. Ironically, this is occurring at a time when the Federal government is doing the exact opposite: the US Treasury is shifting its issuance to shorter maturities to reduce its overall cost of borrowing. While this may make sense in the short-term, the result may be a dramatic increase in the interest rate exposure of the Federal budget. Less municipal supply in short maturities, combined with more Treasury supply, means municipal valuations in short maturities may stay richer than the recent past, and we may not see ratios meaningfully above 100% any time soon. None the less, we hope to take advantage of relative value opportunities when they materialize.
We entered 2014 with a modest allocation to Treasury Inflation Protected Securities (TIPS) as an insurance policy against a successful Fed reflation policy. As we acknowledged in our last commentary the case for materially higher inflation was not supported by the fundamentals, but we viewed the breakeven inflation rates priced into the market as fairly valued. In the opening weeks of 2014 the domestic and overseas economic data seemed to decelerate, and we became concerned that inflation pressures would ebb. As a result, we eliminated our exposure to TIPS. The quarter ended with CPI in the US at a little over 1%, CPI in the Eurozone at barely 0.5%, and TIPS breakevens falling.
We also prepared our portfolios for a flatter yield curve at the start of 2014. As the statistical rich/cheap data in Exhibit 5 on Treasury curve slope shows, the Treasury curve was statistically steep, at a time when our fundamental analysis suggested a flatter curve slope was warranted. We view a flattening as a likely course of action less because of an imminent tightening by the Federal Reserve, but more because a steep curve slope suggests an accelerating rate of inflation and growth – neither of which was consistent with our “muddle along” forecast.
Our muddle along forecast remains our base case for the period immediately ahead of us. Certainly, the disappointing jobs data at the start of the year and the faltering consumer confidence support our view, but so does the weakness in recent Non-Manufacturing and Manufacturing ISM. While both of these benchmarks of economic activity signal expansion, they have weakened. We are also concerned about growing geopolitical tensions and the uncertain impact this will have on consumer confidence and growth overseas.
Our outlook for a softer economy has influenced our view about the likely path of Fed policy. While we do not believe a recession is in the future, we do believe it will take a little longer for the green shoots of an economic acceleration to pierce through the last frosts of our economic winter. Though private sector payrolls are back to pre-crisis levels, the level of underemployment remains high and government austerity programs remain a fiscal drag, even if the period of austerity is easing. While we are disappointed by the recent data, we remain believers in the economy and this supports our overweight to spread sectors. In our portfolio construction, corporate bonds also serve as an internal hedge to a rising rate environment; spread sectors generally outperform in the early days of an economic acceleration as rates begin to rise. For the time being, we believe a true rise in rates remains elusive, and just beyond the grasp of savers hungry for a higher yield environment.
In an environment where yields are likely to remain range bound, we have emphasized an approach to yield curve management and security selection that we call “total return roll down analysis”. In this process we examine not only the relative value yield and spread characteristics of sectors and securities, but the opportunity to enhance returns by investing in securities that will appreciate as they “roll down” the yield curve. Exhibit 7 highlights this roll down opportunity. It is particularly favorable around the 2-year and 3-year maturity area for a variety of reasons. In this frame work, we make the analytical assumption that the slope of the yield curve is constant. A bond that is a 3-year maturity today will have a 2-year maturity in one year. The steep slope of the taxable curve today means that as the bond maturity shortens with the passage of time, its yield will fall, and its price will actually go up.
This roll down opportunity was in part created by a rise in short-term yields we view as unsustainable. We believe that bonds in this short maturity segment of the yield curve are now undervalued – they are priced for a Fed tightening we do not think will occur in the next 12 months. Just as there was a taper tantrum last summer that caused 10-year Treasury yields to spike, creating a short lived buying opportunity, the past few weeks have witnessed a bond market tantrum at the short-end of the yield curve. We believe it too was a market overreaction. This time the bond market was hoping Janet Yellen would give them iron clad assurances that the Fed would not raise rates, but she disappointed. While she did not give any hint of a real policy tightening, her ambiguity, and her decision to shift the Fed towards more qualitative approaches to policy formulation, rather than Bernanke’s rule based approach, was enough to upset Baby Bond Market. And short yields rose sharply as can be seen to the right.
The result of this sharp rise in short maturity yields is that bonds in this segment of the yield curve are undervalued not only through the prism of our roll down analysis, but also by our implied forward yield curve analysis. Exhibit 9 compares the current Treasury yield curve and the one year forward implied Treasury yield curve. The elegance of bond math is we can always extract the market’s prediction of future rates through the simple power of compounding. For example, a 2-year Treasury today yields 0.41%. An investor is indifferent between owning that 2-year note today, or a 1-year T-bill today yielding just 0.10% reinvested in another 1-year T-bill earning 0.72% a year from now. That is the implied forward rate of a one year Treasury, one year from now. The rest of the implied forward curve can be seen in the chart below. In our view, the idea that a 1-year note will be 62 basis points higher in yield 12 months from now would require a level of Fed tightening inconsistent with any reasonable forecast of economic activity. This analysis makes us particularly comfortable with 3-Year maturity bonds, a part of the curve that has built in the possibility of a 77 basis point rise in rates. This is among the factors that have led us to emphasize that maturity in our targeted 3/7 barbell posture.
To harvest the opportunity in this area, we have been building short maturity corporate portfolios that take advantage of the roll down, and the cheapness of this part of the curve on an implied forward basis. We have built these portfolios using our corporate replication investment process and these separately managed accounts provide investors with the benefits of corporates as an asset class, but without the problems associated with the premium discount cycle that has occurred in fixed income sector specific ETFs, an issue we have written about in past commentaries1.
Investors who have been purchasing well-known fixed income ETFs have actually, at times, been paying a material premium for these asset allocation building blocks. Given the low return environment of our time, a meaningful premium above the asset value of the bonds at purchase, that can readily disappear over the holding period or at sale, highlights that fixed income ETFs may not be living up to the hopes of investors who thought them an easy solution for fixed income management.
The iShares 0-5 Year Investment Grade Corporate ETF is a particularly notable example of this phenomenon. During the quarter, the premium was as high as 0.31 and the discount as low as 0.19. These types of swings in the premium/discount cycle mean an investor could invest in fixed income during a favorable time for bonds, but still lose money on the investment due to poor timing of purchases and sales relative to this cycle. A separately managed account avoids this particular risk.
Looking forward, we believe, with the potential economic and geopolitical risks rising, fixed income should play a prominent role in a conservative client’s asset allocation