2nd Quarter 2020 Fixed Income Review
Following a wild ride in the first quarter, fixed income markets had positive performance in the 2nd quarter of 2020, mainly due to the Federal Reserve’s announcement of numerous programs to support liquidity in many sectors. Additionally, world central banks, including the U.S. Federal Reserve, signaled more accommodative policies, with the latter cutting the overnight rate twice in March from 1.50% to a range of 0% to 0.25%.
Below are some 2nd quarter and YTD 2020 Bloomberg Barclays fixed income index returns:
The chart on the following page shows the changes in the UST yield curve from the end of Q2 2019 (gold line) and the end of 2Q 2020 (green line). The bar graph at the bottom shows the changes in yields for select maturities. As a result of the global pandemic, general economic uncertainty, and central bank purchases, U.S. Treasury yields are at or near all-time lows.The 10-year U.S. Treasury (UST) Note, a bell-weather measure used in the fixed income markets, ended Q2 2020 with a yield of 0.66%. An all-time low yield of 0.54% was hit on March 9, 2020. In addition, the UST yield curve “steepened” during the quarter as short-term yields fell more than longer-term yields- globally bond yields fell in general. The 2-10-year UST yield spread differential, an often-cited measure of the slope of the yield curve, ended 2Q 2020 at 51 basis points. By comparison, that same yield spread has averaged almost 70 basis points for the past five years.
In their most recent meeting in June, the FOMC left interest rates unchanged and signaled that they would likely keep interest rates on hold through 2022 amid “considerable risks” to the economic outlook. According to most reports there is unanimity at the Federal Reserve to do whatever it takes to support the recovery.
At their June meeting, the FOMC updated projections for GDP, inflation, and unemployment for 2020. The Fed’s median estimate for GDP is -6.5% versus a 2.00% estimate in December 2019 and core inflation is seen at 1.00% versus 1.90%. The unemployment rate is expected to be 9.3% versus the 3.50% rate expected last December.
Like U.S. Treasuries, most foreign sovereign bond yields moved lower in Q2 2020, although globally, negative yielding debt decreased to around $13 trillion from over $17 trillion a year ago- a positive for investors.
The U.S. fixed income markets have yet to witness the negative yield phenomenon seen in both European markets as well as Japan. It is important to note that most domestic pundits, as well as members of the Federal Reserve, do not expect negative interest rates in the U.S. At present, the use of negative interest rates is an extraordinary monetary tool being implemented by some central banks with untested results and unknown long-term repercussions. Present expectations are for the U.S. central bank to continue selectively purchasing in the open market (Quantitative Easing or “QE”) to support lower rates in targeted sectors of fixed income. This previously considered “unconventional tool” was successfully implemented during the financial crisis and has already shown to be effective supporting asset prices and lowering rates in recent months. “Yield curve control,” a condition where a central bank explicitly targets the yield on Treasury securities to keep them from rising, is another much discussed policy currently being used in Australia.
Below, in blue, are 10-year bond yields from several foreign countries (sorted from low to high). Note the wide difference between the yield of the bellwether German Bund (the German ten-year note) at -0.46% compared to the U.S. ten-year note at 0.66% currently. This marked disparity in yields is indicative of divergent central bank monetary policies as well as differing economic outlooks domestically and abroad.
While always seeking opportunities during periods of market dislocation, we continue to recommend that our core fixed income portfolios maintain high credit quality and shorter, more defensive, durations. We continue to feel any potential upside in longer dated bonds is outweighed by paltry cash flows with interest rates at current levels.
Where appropriate, we continue to believe a core fixed-income strategy utilizing high quality individual bonds evenly “laddered” over several years, and replacing bonds as they mature with longer maturities, provides a good offset for riskier assets or strategies in a balanced portfolio. Described as a “volatility dampening” characteristic, even in an environment of extremely low rates and heightened correlations, this type of structure also provides dependable cash flows and a source of liquidity which may be accessed as more lucrative opportunities become available in other sectors. As always, potential individual bond purchases are pre-screened by our fixed income team for sustainable financial strength, conservative debt coverage ratios, and other favorable characteristics.
These are very unusual times in the financial markets. An unprecedented amount of central bank intervention with historically low (and even negative) interest rates at a time when sovereign deficits balloon to historic levels globally, is a challenging environment to work within. We continue to recommend a broad diversification of fixed income strategies, both conservative and more opportunistic, as a means of preserving capital, creating cash flow, and pursuing positive risk-adjusted returns. We hope you will contact your portfolio manager, or any member of our fixed income team, with questions or comments, and we will be happy to discuss our thoughts further.
