2019 proved to be a very strong year for almost all financial assets, as equities and bonds rallied in tandem. The Federal Reserve (the Fed) was compelled to play defense against a weaker global economy (particularly in Europe) and continued uncertainty related to the trade dispute between the U.S. and China. Three eases in the federal funds target rate (totaling 75 basis points) coupled with significant narrowing of investment grade corporate spreads helped propel the Bloomberg Barclays U.S. Aggregate Bond Index to an 8.72% return for 2019, its best since 2002.
For much of the first three quarters of the year, investors warily eyed the yield curve inversion as a precursor to a recession. However, the combination of three rate cuts (lowering shorter maturity yields) and some improvement in the outlook for U.S.-China trade and the Euro-area economy steepened the Treasury curve, primarily through a rise in longer-maturity yields. When the dust settled, the option-adjusted spread (OAS) of the corporate sector closed at 93 basis points, just 10 basis points away from the tightest levels seen since the financial crisis. The table below summarizes some of the key changes in rates and spreads during the course of 2019.
| |
12/29/2018
|
12/31/2019
|
Change
|
|
Fed Funds Target Rate
|
2.50
|
1.75
|
-0.75
|
|
Corporate Option-Adjusted Spread
|
153
|
93
|
-60
|
|
MBS Option-Adjusted Spread
|
35
|
39
|
4
|
|
2-Year Treasury Yield
|
2.49
|
1.57
|
-0.92
|
|
5-Year Treasury Yield
|
2.51
|
1.69
|
-0.82
|
|
10-Year Treasury Yield
|
2.69
|
1.92
|
-0.77
|
|
30-Year Treasury Yield
|
3.02
|
2.39
|
-0.63
|
|
MOVE (Volatility) Index
|
66.6
|
58.3
|
-8.30
|
In our view, one of the main factors driving the market’s relentless pursuit of risk is how the Fed has portrayed its path forward for rates. It should be noted that the effective federal funds rate is actually 85 basis points lower year-over-year (down from 2.40% to 1.55%) as its target is approaching the floor of its range, whereas a year prior it traded closer to the cap – quietly adding another half ease in the process. Furthermore, we view the Fed as on hold for most of 2020. The hurdle to hike rates requires inflation to print persistently above 2%, which would take time to materialize. Conversely, we would need to see dramatic deterioration in the domestic economy to see the Fed lower rates from here. In other words – with risks balanced and inertia being a difficult force to overcome, the Fed is on hold at what we believe to be a relatively accommodative level. This should limit short-term rate volatility and perceived risks around Fed policy and will allow risk assets to continue to outperform.
Within investment grade corporates, valuations prevent us from being more constructive than we were a year ago. While we have a generally positive view of the economy in the coming months, we recognize that the exceptional outperformance we saw in 2019 is unlikely to reoccur and we have moved from a corporate sector overweight to a more neutral stance. (For a more in-depth discussion of our view, please see our 2020 IG Credit Outlook.) Mortgages, which trailed corporates in 2019, have the potential to outperform as they should benefit from slightly higher interest rates (and slower prepayment speeds) than they had to endure in the middle of 2019. We believe that any volatility in interest rates will be observed in longer maturities, as the Fed will likely keep short term interest rates anchored.
Looking ahead, we feel it will be very difficult for investment grade bonds to repeat their 2019 performance. With rates relatively rangebound and spreads relatively tight, there simply isn’t enough yield for the underlying assets to deliver another high single-digit return for the index. At best, we feel the current yield of the index (2.31% as of year-end) is a reasonable return target for purely indexed investors to achieve. Fortunately, as active managers with levers including sector rotation, security selection, and interest rate risk management – we will look to capitalize on any volatility that the market gives us to provide incremental return without sacrificing overall credit quality. We feel these opportunities will increase as the year progresses.
Finally, we are closely monitoring the 2020 presidential election as it could seriously alter the direction of the markets. Depending on the agenda of the Democratic challenger that emerges to face Donald Trump – and the fluctuation in the perceived probability of said candidate winning the election – the ramification on risk assets, especially at current valuations, could be quite extreme. We expect this to be the primary source of market volatility in the latter half of the year.
We thank you for your confidence in us and welcome any questions or comments you may 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.
No part of this article may be reproduced in any form, or referred to in any other publication, without the express written permission of Osterweis Capital Management.
A basis point (bp) is a unit that is equal to 1/100th of 1%.
Merrill Lynch Option Volatility Estimate (MOVE) Index – USD – is a yield curve weighted index of the normalized implied volatility on 1-month Treasury options.
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.
The Bloomberg Barclays U.S. Corporate Index includes publicly issued U.S. corporate and specified foreign debentures and secured notes that meet the specified maturity, liquidity, and quality requirements. To qualify, bonds must be SEC-registered. The index includes exclusively corporate sectors, including Industrial, Utility, and Finance, which include both U.S. and non-U.S. corporations.
The Bloomberg Barclays U.S. Mortgage Backed Securities (MBS) Index tracks fixed-rate agency mortgage backed pass-through securities guaranteed by Ginnie Mae (GNMA), Fannie Mae (FNMA), and Freddie Mac (FHLMC).
Spread is the difference in yield between a risk-free asset such as a U.S. Treasury bond and another security with the same maturity but of lesser quality. Option-Adjusted Spread is a spread calculation for securities with embedded options and takes into account that expected cash flows will fluctuate as interest rates change.
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. For example, S&P ratings are expressed as letters ranging from 'AAA', which is the highest grade, to 'D', which is the lowest grade.
Holdings and sector allocations may change at any time due to ongoing portfolio management. References to specific investments should not be construed as a recommendation to buy or sell the securities by the Osterweis Fund or Osterweis Capital Management.
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© Osterweis Capital Management
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