The rally in risk assets remained intact during the second quarter of 2021 even as the market came to grips with the recent spike in inflation and began to back away from the reflation trade that pushed yields higher throughout the first quarter. Sentiment stayed bullish in the second quarter, as vaccines continued to prove effective against Covid-19 and stimulus programs provided plentiful liquidity, driving the S&P 500 to all-time highs and investment grade corporate spreads to multi-year tights.
Towards the end of the quarter, investors began focusing their attention on the Federal Reserve (Fed). The June Open Market Committee (FOMC) meeting was one of the most anticipated in recent memory, as the market waited to see if the recent spike in inflation data warranted discussions about rate increases and/or tapering of quantitative easing (QE) measures. The Fed’s post-meeting comments successfully kept the market at bay, with spreads grinding tighter and the yield curve flattening, creating potential opportunities as we position the portfolio for the second half of the year.
The table below highlights the dramatic recovery across the markets during the second quarter.
| |
3/31/2021
|
6/30/2021
|
Change
|
|
Fed Funds Target Rate – Upper Bound (%)
|
0.25
|
0.25
|
-
|
|
2-Year Treasury Yield (%)
|
0.16
|
0.25
|
0.09
|
|
5-Year Treasury Yield (%)
|
0.94
|
0.87
|
-0.06
|
|
10-Year Treasury Yield (%)
|
1.74
|
1.44
|
-0.30
|
|
30-Year Treasury Yield (%)
|
2.42
|
2.07
|
-0.36
|
|
Investment Grade Corporate Option-Adjusted Spread (bps)
|
91
|
80
|
-11
|
|
MBS Nominal Spread (bps)
|
70
|
65
|
-5
|
|
MOVE – Volatility Index
|
71.27
|
57.27
|
-14.00
|
|
VIX – Volatility Index
|
19.40
|
15.83
|
-3.57
|
|
Crude Oil – NY Mercantile (USD)
|
59.16
|
73.47
|
14.31
|
With the unwinding of the reflation trade, 10-Year Treasury yields fell 30 basis points to 1.44%, a level not seen since the beginning of March. By the end of the quarter, markets took cues from the Fed’s transitory narrative and a more aggressive dot plot, leaving the 2-10s Treasury curve near the flattest levels of the quarter at 120 basis points and the 10-year TIPs breakeven at 234 basis points (after reaching as high as 256 bps in May). Economic projections presented at the FOMC meeting showed an increase in core Personal Consumption Expenditures (PCE) for 2021 to 3.0%, from the original March projection of 2.2%, only to fall back to 2.1% for 2022 and 2023. The dot plot revealed the median Fed official expecting a more aggressive timeline, with an initial rate hike in 2023. These revelations from the FOMC meeting seemed to satisfy the market and reinforce expectations that inflation will remain in check under the influence of the Fed.
During the quarter, inflation data continued to be noisy as the effects of supply chain disruptions and labor shortages remained in flux. Even as the prices of certain items have reversed course recently, we carefully watch “transitory” inflation dynamics as we believe current pressures could broaden and cascade to larger sectors of the economy, thus becoming more persistent. We have been observing the success various corporations have had in passing costs through to their end customers to maintain profit margins. We believe these cost increases will be stickier than expected and that there could be broader moves in inflation. Therefore, we remain defensive and see little value in 10-Year Treasury rates at 1.44% as the economy continues to heal. We continue to run a shorter duration as we protect the downside and have also added TIPs to take advantage of recent moves after the FOMC meeting.
As investors looked to the Fed for guidance on the timing of the unwind of stimulus measures, they did get an indication that initial steps are being taken as the economy continues to rebound. During the quarter, the Fed announced plans to sell its corporate bond and ETF holdings, which were purchased as part of the Secondary Market Corporate Credit Facility established in March 2020 during the height of the pandemic. The holdings amounted to approximately $14 billion, a small portion of the $250 billion capacity of the overall facility. The purchases were mostly symbolic of the extent to which the Fed could be relied upon to support markets in times of dislocation, thus reinforcing the idea of the Fed put. The investment grade (IG) corporate bond market paid little attention to the news of the planned sales and continued to bid spreads tighter during the quarter. Spreads tightened approximately 10 basis points to 80 basis points, breaking levels not seen since March 2018. To give some context, the spread on the Bloomberg Barclays IG Corporate Index at the end of the quarter was within 5 basis points of multi-decade tights when it hit 75.8 basis points on March 11, 2005, which was the tightest level recorded since 2000.
Investors were paid to take risk during the quarter as Baa-rated corporates outperformed all other IG ratings categories. Baa-rated corporates tightened 12 basis points compared to the Aaa cohort, which was the laggard, tightening 3 basis points during the quarter. Investors were also paid to buy sectors most severely affected by the pandemic as part of the reopening trade. The finance companies sector (mostly aircraft lessors) performed best in the quarter, tightening 27 basis points, followed by the energy and REIT sectors, both tightening 18 basis points. Given the overall level of spreads, we decreased our exposure to IG corporate credit at the end of the quarter. But we continue to be focused on individual credits that are levered to the reopening of the economy in addition to having the ability to maintain margins through pricing power. Thus, we continue to hold our positions in sectors that include financials, aircraft lessors, and hospitality businesses.
As corporates have tightened to near-record levels, we have rotated part of the portfolio into asset backed securities (ABS). We continue to believe the ABS sector provides attractive risk-adjusted returns that can take advantage of the present short-term inflationary dynamics such as recent price increases in used cars, containers, and housing. The current environment continues to be beneficial for borrowers to service loans and lenders to mitigate losses from defaults by liquidating assets at elevated prices. We have been rotating our portfolio into short ABS and out of the tighter corporates when we see attractive relative value and will continue to do so as deals perform well.
Mortgages were the underperforming sector during the quarter as concerns about tapering remained a challenge. The sector did get some relief as prepayment speeds slowed from the elevated speeds seen in the first quarter. Prepayments in the second quarter hit their lowest levels since April 2020 as mortgage rates continued to rise during the period. Conventional 30-year mortgage rates hit a historic low of 2.65% at the beginning of January then rose to as high as 3.18% at the beginning of the second quarter. Since then, mortgage rates have remained around 3.00%. As prepayment speeds have fallen, investors’ willingness to pay extra for mortgage pools with characteristics that are less likely to prepay has also diminished. In addition, higher coupon mortgages also underperformed lower coupon mortgages during the quarter as expectations of higher rates did not materialize. We have added and look to continue adding mortgage pools with incremental prepay protection in addition to higher coupon mortgages, as we see value in these areas. In addition, we look at other specific mortgage securities that will benefit when the yield curve steepens.
We continue to believe the reopening of the economy remains on track, but we are monitoring news about Covid variants such as the Delta+ and any other developments that may derail progress. Given our outlook, we remain concerned about the amount of liquidity in the system driven by the record amount of stimulus. Consequently, we continue to play defense on our duration exposure and have reduced IG credit as spreads are near multi-decade tights. We prefer opportunities in ABS that take advantage of historically high asset values and we’re also looking in certain areas of the mortgage sector that look attractive given recent moves. Given the current environment, we believe security selection will continue to be of utmost importance as we move forward into the second half of the year.
We would like to thank you again for your confidence in the team and welcome any questions or comments you may have.
Best regards,
Eddy Vataru, John Sheehan, Daniel Oh
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A mortgage-backed security (MBS) is a type of asset-backed security that is secured by a mortgage or collection of mortgages.
The Chicago Board Options Exchange (CBOE) Volatility Index, or VIX, is a real-time market index that represents the market's expectation of 30-day forward-looking volatility
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.
Merrill Lynch Option Volatility Estimate (MOVE) Index – USD – is a yield curve weighted index of the normalized implied volatility on 1-month Treasury options.
A yield curve is a line that plots the interest rates, at a set point in time, of bonds having equal credit quality but differing maturity dates.
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.
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Coupon is the interest rate stated on a bond when it's issued. The coupon is typically paid semiannually.
A basis point is a unit that is equal to 1/100th of 1%.
Consumer Price Index (CPI) is a measure that examines the weighted average of prices of a basket of consumer goods and services, such as transportation, food and medical care.
Credit Quality weights by rating were derived from the most recent data available as determined by Standard and Poor’s. Grades are assigned to bonds by private independent rating services such as Standard & Poor’s and these grades represent their credit quality. The issues are evaluated based on such factors as the 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 situations where Standard & Poor’s has not issued a formal rating, the security is classified as not rated (NR). Additionally, common stocks, if any, are classified as NR.
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