October, 2020
3rd Quarter 2020 Fixed Income Review
Fixed income markets experienced positive performance in the 3rd quarter of 2020, mainly due to the Federal Reserve’s pledge to keep interest rates low through 2023 and continued central bank support of many fixed income asset classes.
Below are some 3rd quarter and YTD 2020 Bloomberg Barclays fixed income index returns:
The 10-year U.S. Treasury (UST) Note, a bell-weather measure used in the fixed income markets, ended Q3 2020 with a yield of 0.68% compared to 0.66% at the end of the second quarter. Generally, Treasuries traded in a narrow range during the quarter, although the 10-year UST did briefly touch a record low yield of 0.51% on August 4, 2020. In addition, the UST yield curve “steepened” slightly during the quarter as short-term yields dropped more than longer-term yields. Global 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 3Q 2020 at 55 basis points. By comparison, that same yield spread has averaged almost 70 basis points for the past five years.
The chart below shows the changes in the UST yield curve from 10/1/2019 (gold line) and 9/30/2020 (green line). The bar graph at the bottom shows the changes in yields for select maturities. As a result of global pandemic uncertainty and central bank purchases U.S. Treasury yields are at or near all-time lows. Since mid-June, the Federal Reserve has purchased $80 billion a month in U.S. Treasuries and $40 billion a month in mortgage-backed bonds, down from even larger amounts in the Spring, as the FOMC worked overtime to support key fixed income markets. Very low interest rates attracted near record amounts of corporate bond issuance during the third quarter as companies in all credit sectors accessed seemingly unquenchable investor demand for cash flow. As an example, year to date issuance of high yield debt has already surpassed amounts issued during all of 2019. The U.S. High Yield Index was the best performing major fixed income index during Q3.
During their most recent meeting in September, the FOMC left interest rates unchanged and signaled that they would likely keep interest rates near zero through 2023 “until the labor market has reached levels consistent with… maximum employment and inflation has risen to 2% and is on track to moderately exceed 2% for some time.” Also in the meeting, The Federal Reserve implemented a new policy tool called “extended forward guidance,” which is nothing more than the Central Bank letting markets know they do not expect to increase interest rates for a prolonged period of time. By giving additional conditions involving the labor market and an inflation rate target the FOMC has provided clear measures which should be used by financial markets to gauge the timing of future policy adjustments. Along with a continuation of their ongoing large scale open market purchases of Treasuries and mortgages, mentioned earlier, the Fed has rather successfully managed to support the economy by keeping interest rates very low even at a time of record Treasury issuance.
At their September meeting, the FOMC also increased their projections for GDP, but lowered their outlook for unemployment for 2020.
Like U.S. Treasuries, most foreign sovereign bond yields moved lower in Q3 2020. Global negative yielding debt has decreased to around $15 trillion from over $17 trillion last year and is concentrated in the Eurozone and Japan. The U.S. fixed income markets have yet to experience negative nominal yields in any material fashion although the entire UST yield curve currently offers negative “real rates” of return when inflation is taken into consideration. With detrimental implications for our banking system and recent statements against the use of negative rates as a policy tool from the FOMC, we believe it is reasonable to assume, barring unforeseen circumstances, we will avoid negative rates here at home, at least for the time being.
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 negative 0.52% compared to the U.S. ten-year note at 0.68% currently. This marked disparity in yields is indicative of divergent 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/primary fixed income portfolios maintain high credit quality and shorter, more defensive, durations. With interest rates at such unattractive levels across the board, we continue to believe that the slightly higher cash flows available in longer-dated maturities are unattractive from an overall risk standpoint. We further feel that a core fixed income strategy utilizing high quality individual bonds (where appropriate) evenly “laddered” over several years, and replacing maturing bonds with longer maturities, provides a good offset for more risky assets or strategies in a well-diversified portfolio. Along with this “volatility dampening” characteristic, a laddered individual bond portfolio also provides dependable cash flow and a source of liquidity which may be accessed as more lucrative opportunities become available in other sectors of the financial markets. As always, potential individual bond purchases are screened for sustainable financial strength, conservative debt coverage ratios, and other favorable characteristics.
As said numerous times before, these are very unusual times in the financial markets. An unprecedented amount of central bank intervention with historically low (and even negative nominal) interest rates is a challenging environment for fixed income investors. In addition, record fiscal deficits and ever-increasing debt issuance by most developed countries in the face of a tepid economic outlook is a textbook case for investor consternation. That said, there are a number of fixed income strategies, both conservative and more opportunistic, which we currently employ along with our core allocations, selectively, as a means of enhancing cash flow, preserving capital, and pursuing positive risk-adjusted returns. We hope you will contact your portfolio manager or any member of our fixed income team to discuss.
