Seizing on the success the equity market had in forcing Federal Reserve (“Fed”) chairman Powell’s hand in January 2019, the bond market decided to take its own swing at dictating Fed policy. Treasuries rallied sharply – although without the requisite widening of corporate or mortgage spreads – signaling that this move was not your generic flight to quality. Instead, it seemed to engineer a self-gratifying outcome – lower rates with the Fed on hold (and perhaps leaning toward an ease). When the dust settled on the first quarter, Treasuries built on their substantial fourth quarter rally and saw rates fall 20-27 basis points (bps) across the yield curve, led by the 5-year point (a signature of this type of rally). With the 5-year yield at 2.24%, it is a full 26 bps below the high end of the range of the federal funds rate. All maturities out to 10-year are now below 2.50%, and while the traditional metric of the 2-year/10-year yield spread never inverted, it is safe to broadly assert that both the Treasury and swap curves have exhibited inversion. Remarkably, the Treasury market’s own barometer of growth – the Treasury Inflation-Protected Securities (TIPS) market – exhibited a recovery of its own, with 10-year breakeven yields rising 16 bps to 1.87%. This was not a repeat of the fourth quarter.
Corporate credit fared particularly well as participants began to leg back into risk assets after the dislocation of the markets at the end of 2018. Credit spreads started 2019 at 153 bps (above Treasuries), peaked in the first week of the year at 157 bps but have steadily compressed to 119 bps by the end of the quarter. The fear of impending doom in the BBB space also faded as investors reached for yield with the Baa sector outperforming higher quality groups. The Baa cohort tightened 39 bps outperforming its higher rated peers (A tightened 29 bps, Aa 23 bps and Aaa 13 bps). New issuance of corporate credit also began the year at an anemic pace but gained momentum with volumes of issuance matching the first quarter of last year of $320 billion. Overall, the corporate sector performed extremely well resulting in an excess return versus duration-matched Treasuries of 2.66%, which was its best quarter since 2012. And not to be totally ignored, mortgages also outperformed duration-matched Treasuries by 27 bps.
Looking forward, we are loath to invest in the belly of the yield curve – specifically maturities between 3-7 years. We believe the rally in this part of the curve is completely overdone. However, we believe the support from global central banks and a reemergence of growth will be supportive for credit, and we will likely maintain an overweight to spread product and TIPS in the short-intermediate term. We believe the second and third quarters will be a period of consolidation in the rates markets, but that economies globally will begin to respond to the incremental central bank stimulus (in particular by the ECB and China). Security selection will become more and more important as spreads tighten and offer less margin for error. As we have pointed out previously, we expect significant differentiation between winners and losers – especially in lower-rated corporates. Mortgages remain somewhat attractive versus Treasuries despite a substantial uptick in the Mortgage Bankers Association Refinance Index in March; we believe any refinance event will be relatively contained and limited to high quality borrowers that originated loans in the last 12-24 months (at higher rates).
In the portfolio, we took advantage of the volatility late last year and added long credit and TIPS exposure. While we reduced these holdings a bit during the first quarter as both asset classes posted solid returns to add mortgage-backed security exposure, we expect to maintain a substantial position in both corporate bonds and TIPS (in lieu of nominal Treasuries). We also maintain our non-consensus view that the next Fed rate move will be a hike, although probably not until 2020 – and as a result, expect to be reasonably defensive in our duration exposure. Specifically, we are satisfied with earning attractive yields at the very front-end of the yield curve, coupled with some exposure in the long-end of the curve (10+ years), particularly in corporates where spreads still have some room to tighten. We favor taking spread duration risk over interest rate duration at these levels of rates and spreads.
As always, we thank you for your support and welcome any questions or comments you might have.
Best Regards,
Eddy Vataru, John Sheehan, Daniel Oh
Past performance is no guarantee of future results. This commentary contains the current opinions of the authors as of the date above which are subject to change at any time. This commentary has been distributed for informational purposes only and is not a recommendation or offer of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but is not guaranteed.
The Osterweis Total Return Fund may invest in fixed income securities which are subject to credit, default, extension, interest rate and prepayment risks. It may also make investments in derivatives that may involve certain costs and risks such as liquidity, interest rate, market, credit, management and the risk that a position could not be closed when most advantageous. The Fund may invest in in debt securities that are un-rated or rated below investment grade. Lower-rated securities may present an increased possibility of default, price volatility or illiquidity compared to higher-rated securities. Investments in foreign and emerging market securities involve greater volatility and political, economic and currency risks and differences in accounting methods. These risks may increase for emerging markets. Leverage may cause the effect of an increase or decrease in the value of the portfolio securities to be magnified and the Fund to be more volatile than if leverage was not used. Investments in preferred securities have an inverse relationship with changes in the prevailing interest rate. Investments in Asset Backed and Mortgage Backed Securities include additional risks that investors should be aware of such as credit risk, prepayment risk, possible illiquidity and default, as well as increased susceptibility to adverse economic developments. It may also make investments in derivatives that may involve certain costs and risks such as liquidity, interest rate, market, credit, management and the risk that a position could not be closed when most advantageous. The Fund may invest in municipal securities which are subject to the risk of default.
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The Bloomberg Barclays U.S. Aggregate Bond Index (BC Agg) is an unmanaged index that is widely regarded as a standard for measuring U.S. investment grade bond market performance.
Mortgage Bankers Association Refinance Index measures the number of new refinance applications submitted and is reported every Wednesday.
It is not possible to invest directly in an index.
A basis point (bp) is a unit that is equal to 1/100th of 1%.
Treasury Inflation-Protected Security (TIPS) refers to a Treasury security that is indexed to inflation in order to protect investors from the negative effects of inflation.
Duration measures the sensitivity of a fixed income security's price (or the aggregate market value of a portfolio of fixed income securities) to changes in interest rates. Fixed income securities with longer durations generally have more volatile prices than those of comparable quality with shorter durations.
Credit Quality weights by rating are derived from the highest bond rating as determined by Standard & Poor’s (“S&P”), Moody's or Fitch. Bond ratings are grades given to bonds that indicate their credit quality as determined by private independent rating services such as S&P, Moody's and Fitch. These firms evaluate a bond issuer's financial strength, or its ability to pay a bond's principal and interest in a timely fashion. Ratings are expressed as letters ranging from 'AAA', which is the highest grade, to 'D', which is the lowest grade. In limited situations when none of the three rating agencies have issued a formal rating, the Advisor will classify the security as nonrated.
Osterweis Capital Management is the adviser to the Osterweis Funds, which are distributed by Quasar Distributors, LLC.
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© Osterweis Capital Management
© Osterweis Capital Management
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