Thornburg Income and U.S. Government Bonds Second Quarter 2016 Commentary
Learn more about this firm"(A)nd therefore never send to know for whom the bell tolls; it tolls for thee." John Donne, the writer, was certainly not referring to U.S. Treasury rates when he penned those words so long ago. In fact, he was discussing how all living beings are connected to one another as well as to the world. But today, this sentiment seems quite fitting as we contemplate the world of U.S. dollar–denominated fixed income. The usual suspects are at work: U.S. economic growth, inflation expectations, the Federal Reserve, etc. And yet they increasingly do not seem to explain why Treasury rates are so low, or why the term premium on 10-year U.S. Treasuries is markedly negative. Rather, it appears the global interest rate environment and the interconnectedness of capital markets are at work here. More than $10 trillion in global sovereign debt currently yields less than zero. The Swiss 10-year stands at negative 69 basis points (bps). The German 10-year offers negative 18 bps. The Japanese 10-year is at negative 28 bps and its 30-year is at 4 bps. In a low-yield world such as this, the U.S. 10-year at 1.38% and 30-year at 2.14% look quite attractive on a relative basis. This doesn't mean U.S. rates will necessarily join these developed world counterparts in negative territory, though it is possible. Foreign exchange rates, fiscal policy, regulators, U.S. economic dynamism, and other important elements will also come into play. However, it will serve us all well to remember that "no man (or, in this case, interest rate regime) is an island" and U.S. rates are likely to stay within sight of those of Germany and Japan. With that in mind, let's take a look at what happened in the quarter and how the funds are positioned now.
Until the last few days of the second quarter, the unabated strength of the credit market was the story. Investors continued to gobble up yield offered by spread products—corporates, mortgage-backed securities (MBS), asset-backed securities (ABS), etc.—despite so-so economic and company fundamentals, believing global central banks are perpetually willing AND able to apply liquidity liberally and thus protecting them from negative outcomes. Even commodities remained well-behaved, increasing in price in some cases, but overall supporting the credit rally. For example, corporate bond spreads declined 17 bps in April to 146 bps and settled in around 150 bps by the third week in June, having given a few basis points back following heavy new issuance in May and early June. ABS spreads tightened over that entire period. Then, on June 23, the United Kingdom voted to leave the European Union, and as a result of "Brexit," it was risk-off time. Market volatility immediately spiked. The British pound fell over 10%. The S&P 500 Index declined 5.4%. Corporate spreads increased 11 bps. Only safe-haven assets, such as U.S. Treasuries, rallied. The 10-year Treasury yield fell 35 bps on June 23 before closing down 18 bps and then falling an additional 12 bps the next trading day. While the true ramifications of the U.K.'s vote won't be known for years (if Brexit actually occurs), by the third day post-Brexit, investors decided the short-term damage was too great and markets began to rally. In fact, markets rallied into quarter end, erasing much of the decline in risk-asset prices. Risk-free assets (U.S. Treasuries, Japanese government bonds, German bunds) and foreign exchange rates, meanwhile, continued along the path initiated by Brexit...central bank(s) power, activate!
The most disappointing aspect of the Brexit vote was that the market mayhem did not last very long at all. We were positioned to provide liquidity to the market and opportunistically add risk, but there were few opportunities to do so. This reflects the mostly orderly nature of activity within investment-grade fixed income (i.e., there wasn't much), but also how far corporate credit spreads had run. Some bond spreads moved wider, but they were still not very attractive. As we've mentioned a time or two before, we are happy to take risk, but we must be paid appropriately to do so. As such, with lower compensation for risk prevailing generally, we increased the quality of the portfolios, holding more cash and buying bonds such as highly liquid, short life, senior tranches of credit card and auto loan ABS. In addition, we sold some of our short maturity Treasuries into the Brexit-led rally. While the duration risk presented by these securities wasn't great, the market reacted so severely that market-based probability of a Fed rate hike in December 2016 declined from 50% to 15%, with the probability of a Fed rate cut in any of the next several meetings increased from 0% to low teens. The market-based probability of a rate hike one year from now is only 27%. We would agree the likelihood of a Fed hike has declined post-Brexit, but we believe the market has moved too far, shifting the risk-reward balance too much toward risk, leaving short-term rates highly exposed to favorable economic developments.
In summary, the portfolios remain positioned toward the shorter end of their respective historical duration ranges. Foreign buyers may keep longer maturity Treasuries range-bound and lower in yield than they might otherwise be, but given negative term premiums and negative or low real yields, we don't see much value in adding duration here. We have increased the quality of the credit exposure in the funds and increased our cash holdings, but we continue to look for opportunities to add risk where and when it is appropriate. We will continue to be patient and prudent.
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