Published on Oct. 16, 2019
Third Quarter 2019 Fixed Income Commentary
Thoughts from our Domestic Fixed Income Team
U.S. fixed Income markets rose for the third consecutive quarter; with the ICE BofA U.S. 1-10 YR Intermediate Corporate Index up 1.81%, the ICE BofA U.S. 1-10 YR Treasury and Agency Index up 1.15%, and the ICE BofA U.S. Fixed Rate Preferred Securities Index up 3.05% as a result of a decline in overall US Treasury yields, the yield curve flattening and investment grade credit spreads ending the quarter in line with where they started.
We believe that the majority of the third quarter’s performance was driven by the decline of U.S. Treasury rates, with yields on intermediate and long-term maturity securities experiencing a greater decline than the yield on respective shorter-term securities, effectively causing the yield curve to flatten. This phenomenon, called a bull flattener, drove the prices of longer duration assets significantly higher. Moreover, investment grade credit spreads ended the quarter in line with where they started, only temporarily widening by as much as 15bps during the mid-August market volatility, and signaling to the market that the brief inversion in the 2-10 year segment of the curve was not signaling a recession.
Macro drivers which are closely monitored by the team include the Federal Reserve’s monetary policy actions as well as early signals of potential recession; among the latter we are constantly measuring deflationary versus inflationary risks as well as where to find incremental spread/yield in an environment that continues to decline towards lower and lower nominal and real yields.
In general, we are sanguine that the US offers a “Goldilocks Environment” for fixed income investors, in that the economy is neither too hot nor too cold, and that the nominally higher yield environment in the US versus the rest of the world should continue to support stable if not rising fixed income prices.
Apparent signs of global manufacturing deceleration (predominantly in China and Germany) led the U.S. Federal Reserve to join other central banks around the world in adopting an accommodative monetary policy, as the committee voted to reduce the Federal Funds interest rate by 25bps at each of the July and September FOMC meetings this year. This contributed to the brief yield curve inversion in the 2-10 year maturities, leading to widespread concerns that the U.S. economy was decelerating meaningfully.
While manufacturing statistics are a widely watched set of leading economic barometers, the manufacturing segment of the US economy is getting smaller every year relative to the services segment of the economy (manufacturing is now less than 15% of GDP). The services side of the economy, where consumer spending resides, has not slowed to levels which in our view would pose a problem.
Other signs of economic vitality were evidenced by recent data indicating that building permits, housing starts, and home sales began to improve. This was likely driven by lower rates leading to lower refinancing and mortgage rates, coupled by strong employment conditions in areas of the US economy outside of the manufacturing sector. Also helping to support the expansion are the elevated levels of consumer sentiment that we believe are needed if consumers are going to continue to spend.
Lastly, the Fed is set to resume balance sheet expansion later this month and may reduce its benchmark rate at least one more time before year end. In this environment, the path of least resistance is up and therein lies the goldilocks situation for fixed income investors; meaning the economy is not too hot and not too cold and that the nominally higher yield environment in the U.S. versus the rest of the world (with predominantly negative yields) should continue to support stable if not rising fixed income prices.
Roosevelt’s CIP portfolio is constructed to attempt to balance the exposure to interest rate and credit risk while maintaining high coupon income and principal preservation. The portfolio’s duration is managed to be intermediate in length, so as not to leverage exposure to a particular segment of the curve. As a result, our portfolio may experience less price volatility from moves in interest rates both up or down, since our laddered approach typically spreads out interest rate sensitivities for our corporate bond sleeve.
We believe that the CIP preferred sleeve becomes increasingly important in a low nominal interest rate environment. Preferred securities of investment grade companies can significantly enhance yield without taking on significant credit risk in order to do so. This helps provide a balanced approach to producing attractive amounts of current income in a world where, in many countries, negative interest rates have become the new normal.