Still Waters Run Deep: Total Return Outlook Fourth Quarter 2021

At first glance, the third quarter appeared to be a calm stretch for investment grade bonds, with the Bloomberg U.S. Aggregate Bond Index (Agg) finishing the period roughly unchanged. However, beneath the surface, the market began to experience an undercurrent of concerns that will likely impact pricing for the near term and beyond. Over the course of the quarter, the market’s focus shifted from worries about the Delta variant to the dual threats of persistent inflation and the announcement from the Federal Reserve (Fed) that it will begin tapering its bond purchase program.

The table below highlights the modest moves across the markets during the quarter.

	6/30/2021	9/30/2021	Change
Fed Funds Target Rate – Upper Bound (%)	0.25	0.25	-
2-Year Treasury Yield (%)	0.25	0.29	0.04
5-Year Treasury Yield (%)	0.87	0.99	0.12
10-Year Treasury Yield (%)	1.44	1.53	0.09
30-Year Treasury Yield (%)	2.07	2.09	0.02
Investment Grade Corporate Option-Adjusted Spread (bps)	80	84	4
MBS Current Coupon Spread (bps)	67	71	4
MOVE – Volatility Index	57.27	61.07	3.80
VIX – Volatility Index	15.83	23.14	7.31
Crude Oil – NY Mercantile (USD)	73.47	75.03	1.56

We are in an environment where the impact of the Fed is hard to overstate. Near the end of the quarter, they finally acknowledged that inflation may not be as “transitory” as originally anticipated, and they also announced tapering could start as early as November. Given their outsized influence on markets, both statements were troubling to investors.

Not surprisingly, the rates market reacted most strongly to the news, as volatility increased and Treasury yields climbed across the curve. Treasuries retraced a portion of their second quarter gains, with the intermediate maturities performing the worst and the 5-year bond yield eclipsing 1.00% for the first time this year. Interestingly, this market reaction could be seen as a vote of confidence in the Fed, as the slowing of asset purchases will cause short maturity yields to rise more than longer maturity yields. Longer maturity securities are more vulnerable to inflation expectations, so the modest 2 basis point increase in 30-year yields is a sign that investors feel that the Fed can control long-term inflation even as it pares back its bond purchasing program. We are a little less sanguine, as we believe inflation is likely to be more persistent than the market currently expects. We closely follow the New York Fed’s Underlying Inflation Gauge (UIG), which is designed specifically to measure the persistent elements of inflation, and it ended August near 4% - roughly double the Fed’s 2% target.

Despite the overall rise in rates, the Bloomberg U.S. Treasury Index returned 9 basis points for the quarter. Continued supply chain disruptions led investors to look for ways to hedge inflation, propelling the Bloomberg U.S. Treasury Inflation Notes Index to an eye-popping 1.75% for the quarter. Inflation-linked securities are pegged to CPI and perform better when inflation increases. Additionally, 10-year breakeven rates for Treasury Inflation Protected Securities (TIPS) ended the period 14 basis points above the third-quarter low, which more than offset the rise in yields across the nominal Treasury curve. (The breakeven yield of a TIPS is the difference between the real yield of the TIPS and the yield of the same maturity nominal Treasury.) The breakeven yield is often a metric used to measure the demand for TIPS, and the higher breakeven spreads speaks to strong TIPS demand.

Mortgage Backed Securities (MBS) were the best performing sector in the Agg, but only by a fraction of a basis point. MBS spreads traded in a tight band for the quarter and ended little changed. In addition, MBS benefitted from greater carry and shorter duration than Treasuries. It is important to note that the pending tapering of the Fed’s asset purchase program is intended to slow the pace of purchase (i.e., the Fed will still buy mortgages, but at a lower volume). The Fed currently owns 32% of the MBS market, so increasing their ownership at a slower pace is not seen to negatively impact MBS prices. The scale of the Fed’s MBS portfolio is far more important than the pace of their buying.

Asset Backed Securities (ABS) also posted a positive return for the quarter. ABS performance has been driven by the trifecta of borrowers’ improved ability to meet their obligations (largely as a result of the multiple stimulus plans), price appreciation of the underlying assets (used cars and shipping containers in particular), and their shorter duration profile.

The Bloomberg U.S. Corporate Bond Index was flat for the quarter. In our view, the single biggest input to the lackluster return of corporates was their starting valuation. The option-adjusted spread of the index began the quarter at 80 basis points, which was the tightest that it had been since 2005. When you consider that the duration of the index now is significantly greater than in 2005, the risk/reward profile looks that much less attractive. Adding to the headwinds of valuation, corporations took advantage of the favorable environment over the quarter and issued close to $100 billion in the month of July. On the positive side, investment grade corporate issuers have improved their balance sheets by paying down debt, which has reduced leverage across the sector by almost a half turn. The bulk of this improvement has come from BBB issuers. Single A issuers are still the most at risk for behavior that is unfriendly to bond holders, which was reflected in their negative 12 basis point return for the quarter.

We continue to see inflation as the greatest challenge for the market. While some investors have started to price inflation risk more in line with our thinking, we still think that prolonged elevated inflation could lead to further repricing. We also believe that the market can withstand a predictable slowing of the pace of Fed purchases, but it may struggle should the Fed be forced to accelerate their taper in order to combat inflation. Over the course of the third quarter, we increased our exposure to ABS and TIPS while keeping corporates and MBS largely unchanged, and we anticipate a similar stance for the balance of 2021 based upon current valuations. The return profile of ABS looks attractive relative to corporates when considering duration exposure and credit risks. TIPS remain the only asset that offers direct protection against inflation. It is always easier to identify turning points in markets with the benefit of hindsight, but we feel that the calm waters at the surface are hiding dangerous currents beneath.

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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The Bloomberg U.S. Aggregate Bond Index (BC Agg) is an unmanaged index which is widely regarded as the standard for measuring U.S. investment grade bond market performance. This index does not incur expenses. The index includes reinvestment of dividends and/or interest income.

The Bloomberg Barclays U.S. Treasury Index consists of public obligations of the U.S. Treasury with a remaining maturity of one year or more.

The Bloomberg US Treasury Inflation-Linked Bond Index measures the performance of the US Treasury Inflation Protected Securities (TIPS) market.

The Bloomberg 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.

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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