Fixed Income Outlook: Spread is not dead
June was an interesting month. First the Fed appeared to be encouraging the markets to think about what happens when it starts pulling back on quantitative easing. Then, when the market reaction was perhaps more volatile and rapid than the Fed was anticipating, policymakers acted to rein in the seemingly 24/7 talk about the timing of tapering. Then, after its latest policymaking meeting, Fed Chairman Ben Bernanke put the tapering talk back in the spotlight, prompting a sharp sell-off in Treasuries as well as risk assets.
We don’t think this game of “Fedspeak,’’ in which Bernanke et al seem to be talking out of both sides of their mouths, is entirely by accident. On the contrary, it appears to us that this may be a deliberate attempt to throw various scenarios out there to see how the markets respond and, if central bankers feel the markets are getting ahead of themselves, to tweak the message to settle things down. Given the constructive economic fundamentals of late, we wouldn’t be surprised if policymakers were OK with a 3.00% to 3.50% yield on the 10-year Treasury a year from now—they would just prefer the road getting there isn’t an overly bumpy one, i.e., they want the moves to be driven by data, not market emotion.
Duration at 90%
So where does that leave us in the fixed-income universe as we head into the summer period? Surprisingly, about where we were when we started the second quarter—short duration on anticipation rates at current levels are more likely to rise than fall. We lowered duration to 90% following June’s policymakers’ meeting but could raise it in our tactical portfolios if we start seeing a pullback (though we’d be surprised to see a sustained move down in yields in this constructive economic environment). We also remain overweight spread product, i.e., taxable high-yield, emerging-market (EM) and investment-grade corporate bonds.
Getting to this point has been quite an adventure. After a profitable first month of the second quarter, spread product sold off from early May through early June on the spike in 10-year Treasury yields, which jumped from an intraday low of 1.61% on May 1 to an intraday high of 2.27% on June 11, before falling back a bit only to spike above 2.50% after the policy-setting Federal Open Market Committee meeting and, more significantly, Bernanke’s comments in his post-meeting press conference, in which he signaled a pullback in the $85 billion in monthly Treasury and agency purchases could begin this fall. We believe the market’s reaction was not entirely irrational, as the 1.61% level represented an artificially low level driven by the extraordinary Fed purchase program. When the length and breadth of the QE program was called into question, the market moved to a level more—but still not entirely—consistent with improving economic fundamentals, including housing, auto and retail sales, even jobs. When it got more clarity this week (potentially moderation in purchases this fall, with QE ending next summer), it moved a little more.
What has been somewhat surprising is the correlation between the Treasury and spread sectors. Typically when Treasury rates back up, spreads absorb some of the increase, i.e., the gap between yields on Treasuries and comparable maturity taxable bonds narrow. In recent few weeks, however, spreads actually widened as yields on spread product rose faster than Treasury yields. We attribute this to two relative concepts: First, bond managers reacted to outflows in bond allocations by “selling what they own.” Because the spread sector overweight is so engrained in the market, this led to selling in investment-grade corporate, high-yield and EM sectors. Second, because Wall Street has systemically reduced its ability to position inventory, the lack of overall liquidity in the bond market caused yield levels in these popular spread sectors to increase more than corresponding Treasuries, where the Fed remains the predominate player.
Sell into Treasury rallies
Thus, our market recommendations are as follows. On the Treasury side, while clearly some value has been restored in rates with the recent rise, we still think that rates should still be biased upward, albeit in a slower fashion than what we just experienced. Additionally, from a yield-curve perspective, further rate increases are likely to be more balanced across the curve, and not just a bearish steepening on the long end where the run-up occurred. Bottom line: we would still be biased to sell into Treasury rallies.
Add to spread product
On the spread side, nothing fundamental has changed, so we view this recent spread widening as a buying opportunity on expectations that investment-grade, high-yield and EM sectors should resume their outperformance versus Treasuries, particularly as spreads have returned to levels at or above their historic averages. These sectors provide good income and total return potential with less volatility than equities.
Finally, watch Treasury Inflation-Protected Securities (TIPS)—recent declines in break-even levels have caused significant underperformance in this sector. While recent inflation numbers have been fairly benign, and the reasonable expectation is that longer-term inflation risks will be reduced if the Fed begins to pull in the reins a bit, the Fed has been very consistent in its desire for inflation to increase to the 2%-2.5% area to help ensure continued economic growth. Given the Fed’s history of policy uncertainty and overshoot, we continue to believe that TIPs represent a relatively inexpensive option for a possible outlier scenario in the Fed’s grand QE experiment.