Taxable Fixed Income, Q2 Review

After a positive first quarter, taxable fixed-income markets enjoyed an encore favorable performance for the second quarter. U.S. and global economic data, geopolitical unrest between Russia and the Ukraine over Crimea, the threat of civil war in Iraq, and short-covering trades by desks on the wrong side of interest-rate movements provided for a very active fixed-income trading environment. Entering second quarter, some expected a higher-rate environment on the horizon, and events impacting the market precipitated daily sessions characterized by strong rallies and sessions of emotional selling. When the dust was finally settling, it was clear that geopolitical events and the perception of a weaker overall global market outweighed domestic economic perceptions and pushed an impressive “flight to quality,” thereby resulting in a lower-rate environment than originally expected to end the first half of 2014.

At the close of the first quarter, 10-year Treasuries were trading around yields of 2.80% and the 30-year at yields around 3.64%. Approaching the close of the second quarter, we saw yields decline to 2.60% and 3.41, respectively. Over the past three months, economic numbers continued to disappoint the investing communities. Data appeared to offer steady signs of strengthening; however, the domestic economic momentum reflected in these releases was not robust enough to trigger a change in the trajectory of the Fed’s current rate policy. June’s FOMC meeting and subsequent language that followed seemed to agree.

Throughout the quarter, it seemed that, for each step forward the U.S. economy might have taken toward strengthening, geopolitical events hampered potential progress and forced a step backwards, limiting monetary and economic decisions to cautious baby steps. With the tapering decision now behind us, market focus has shifted to the eventual move by the Fed to begin raising short-term rates. Obviously, at this inflection point, the market landscape will be expected to change. Current market opinions are forecasting this to happen toward the middle or end of 2015. It has been reported that traders are pricing a 59% chance that the Fed will begin raising rates as early as July of next year (Zachariahs & Anchalee, Bloomberg).

From beginning to end, the second quarter reflected three primary themes: curve flattening, spread tightening, and an increased focus on volatility. Taking a closer look at each of these is essential in an effort to paint a vivid picture of taxable fixed-income assets and how these themes impacted the asset classes’ overall temperament and performance in the dynamic fixed-income market.

We actually began to see some curve flattening after the March 19 FOMC meeting, which alluded to a more hawkish policy approach supported by what appeared to be strengthening and improving labor market indicators. The market sell-off that followed pushed rates back up as we ended the first quarter. In April, a significant “flight to quality” provided more evidence of the flattening theme, primarily between the 10- and 30-year tenors. Unrest in the Crimea/Ukraine regions and continued conflicts between the West and Russia’s President Putin prompted many investors to run to the safety of U.S. sovereign debt for several trading sessions. As the market continued to react and conditions became tenser, Treasury market rallies pushed the 30-year Treasury to the lowest yields seen in nine months while also suppressing yields in the 10-year Treasury.

The graphic illustration below allows us to observe the movement of the Treasury curve from the beginning of 2014 (green/top) as compared to the current curve (yellow/bottom). Immediately we are able to see pressures pushing down yields from the intermediate to the long end (7Y-10Y tenors), thus flattening the yield slope. Furthermore, this illustration shows a slight slope steepening for shorter maturities within 3-5 year tenors.

Source: Bloomberg. Green/Top line: curve at beginning of 2014; Yellow/Bottom line: current curve.

The second theme of this quarter was the continued spread tightening of taxable fixed-income assets relative to their Treasury benchmark counterpart. Seemingly all sectors of this asset class were again subject to further spread tightening (agencies, corporates, taxable municipals, BABS & MBS). As a matter of fact, some asset classes were experiencing levels of spread tightening that hadn’t been observed since 2007. For instance, approaching the end of the quarter, investment-grade corporate bond spreads over Treasuries were reported to be at seven-year lows, offering minimal returns over Treasuries investments. Additionally, some seasoned agency-collateralized mortgage obligations (CMOs) were pricing 20bps tighter than they were in first-quarter trading sessions. Market rallies offered attractive levels for continued rebalancing of our taxable fixed-income strategy, enabling us to make tactical changes to portfolio barbell weights and duration targets, as we were able to close out of longer maturities and reinvest in short duration assets.

The final theme observed this quarter centered on market volatility. Volatility as measured by the MOVE Index has been reported to be at record lows (55.53 as of 6/19/14). Pre-financial crisis levels spiked to 264.60 on 10/10/08, and the reported low was 48.87 on 5/9/13. (MOVE Index, Bloomberg). These lows have cautioned members of the Fed for some time. While some traders perceive volatility concerns to be overplayed, low volatility does raise concerns for many (not just the Fed) and indeed does prompt us to ask, “Have we simply become too complacent with today’s low-rate environment?” At Cumberland, we have not become complacent and have monitored these low volatilities judiciously. We have adjusted our strategies to defend against potential increases in volatility metrics as market conditions change and economic forecasts dictate.

Looking forward, we believe the interest-rate environment will continue to remain low for some time, given expectations that the Fed will increase short-term rates towards the end of 2015. Economic numbers are still not strong enough to support an aggressive rate-hike schedule. Unemployment levels are still too high. GDP growth is still not at a pace to support a strong economy. Inflation is always a concern, however not one on the immediate horizon. In our opinion, unless significant data begin to indicate a stronger economy, we don’t foresee much deviation from our current strategy in light of current market dynamics. That said, our strategies will continue to focus on duration shortening, credit enhancement, selling into the rallies, raising cash weights, and looking for opportunities for value-added trades in portfolios.

Nannette L. Sabo, Portfolio Manager & Vice President - Taxable Fixed Income Trading