Published on Jul. 20, 2020
Second Quarter 2020 | Fixed Income Commentary
Domestic financial markets rallied across the spectrum during the second quarter of 2020. Equity indices had their strongest quarter since 1987. Fixed income credit spreads rallied, recording their second-best quarter since 2005. We believe that the re-opening of state and local economies led to a resurgence in economic activity that beat expectations over May and June. The unemployment rate, after reaching an eighty-year high of about 14.7%, dropped to an estimated 11.1%. Other economic indicators such as consumer confidence, consumer and business spending, housing starts, as well as surveys of manufacturing activity, surprised to the upside over the past two months.
The Current Income Portfolio separately managed account returned 7.30% during the second quarter, as declines in interest rates and credit spreads helped push up the prices of corporate bonds and preferred securities, while having less of an effect on government bonds. We believe that the decline in bond yields came from a reversal in risk sentiment as financial markets digested the monetary and fiscal stimulus programs set up in response to the pandemic.
In March, the Federal Reserve re-emerged as the lender of last resort, introducing $2.3T in monetary stimulus programs to restore liquidity and financial stability to the markets. In doing so, the Federal Reserve expanded its asset purchasing program to include ETFS and corporate bonds, in addition to the approximate $120B of government and agency securities it currently buys each month. The program, known as the Secondary Market Corporate Credit Facility (SMCCF), began buying high quality corporate bond ETF’s on May 16th, at a pace of about $300M per day, and individual high quality corporate bonds on June 17th, albeit at a slightly slower pace. The entire amount of secondary market ETF and corporate bond purchases currently stands at approximately $6.8B as of June30, with the ability to go up to about $750B if needed. This extends an incredible amount of support to the investment grade fixed income market, as corporate bond purchasing has just begun and the Federal Reserve is already the second largest holder of Vanguard’s Short-Term Corporate Bond ETF (VCSH), and third largest holder of the iShares Investment Grade Bond ETF (LQD).
The Federal Reserve, however, has not been alone in buying U.S. corporate bonds this year. Even as companies have issued record amounts of new debt to shore up liquidity on their balance sheets, the issuance has been met with equally strong investor demand. Fixed income buyers have absorbed over $1T in new supply year to date; which, in turn, has helped send credit spreads on intermediate investment grade bonds lower by over 150bps during the second quarter.
With signs of a V-shaped recovery emerging from economic data and subsequently called into question as the number of new COVID-19 infections is rising, we believe the outlook for the economy as a whole for the rest of the year remains uncertain. The outlook for investment grade fixed income markets, however, is much more favorable, in our opinion. The current support from the Federal Reserve should serve as a significant backstop and important distinction between high grade and high yield fixed income markets going forward. High yield markets also happen to be concentrated in segments of the market that we see as more susceptible to an economic downturn, such as the consumer cyclical and energy sectors. Investment grade companies, on the other hand, are generally larger, more diversified, less levered and more concentrated in defensive sectors. This, coupled with the recent message delivered by Federal Reserve Chairman Powell saying, “We’re not thinking about raising rates. We’re not even thinking about thinking about raising rates,” could provide for a benign and favorable interest rate environment for high grade fixed income for the foreseeable future.
In our view, the Current Income Portfolio is well positioned to deliver consistent and reliable income regardless of the economic uncertainty that prevails. We believe our risk-conscious approach to portfolio construction ensures a balance between enhancing income without taking on excessive risk to do so. We continue to navigate the financial markets’ ups and downs while attempting to provide investors with high quality risk-adjusted returns.