It helps that we know the unknowns It helps that we know the unknowns\images\insights\article\risk-reward-small.jpg April 27 2020 April 8 2020

It helps that we know the unknowns

We're in somewhat of a holding pattern as we await clarity ... and opportunity
Published April 8 2020
My Content

The March 26 weekly jobless claims number totaled nearly 3.3 million, more than 10 times the average of the last 60 months, and the subsequent week saw claims jump more than 6.6 million, bringing the 2-week total to almost 10 million—wiping out all the nonfarm job gains over the past four years and confirming what investors already had figured out. A virtual government shutdown of the economy due to Covid-19 is going to produce extraordinary downside statistics and continued volatility in markets.

This extreme economic reality created wide divergences in the various segments of the fixed-income markets during the first quarter, concentrated in the final six weeks, with the high-quality Bloomberg Barclays Government Index registering a total return of 8.15% while the Bloomberg Barclays High Yield 2% Constrained lndex returned -12.7%. This greater than 2,000 basis points difference happened only once before—the fourth quarter of 2008 amid the global financial crisis.

At the beginning of the year, we felt things were about as good as they were going to get for most of the credit sectors. With the economy and corporate profits continuing to grow, there was potential for more upside. But given historically rich levels across the corporate credit universe, the potential reward wasn’t much relative to the risk of something possibly going wrong. Hence, our multi-sector fixed-income model was underweight much of the credit market.

We were a little cautious, but not for this reason

In no way is this meant to suggest we were prescient—we did not foresee the cataclysmic impact a new coronavirus being reported in central China ultimately would have on the global economy and assets. But at least our portfolios had reduced exposure in corporate credit as the virus crisis exploded, wreaking havoc on all risk assets and causing yield spreads relative to comparable-maturity Treasuries to gap out. Outside of cash and very short-term Treasuries, there were few places to hide.

On an absolute basis, few win when the markets are going down so far and fast. Pricing dislocations and liquidity/cash flow issues almost always detract from regular investment processes. But on a relative basis, our sector performance benefited precisely because we had taken steps to limit exposure. We even picked up alpha in the quarter’s closing weeks after raising our exposure where we saw potential value at beaten-down levels, with shifts to overweight in mortgage-backed securities (MBS) and neutral in both investment-grade credit and commercial MBS. We also lightened our underweights to high yield and emerging markets.

Where do we stand now? Somewhat in a holding pattern. As the inaugural week of the second quarter has shown, the markets are going to remain volatile until there’s an all-clear. The good news is we know what the unknowns are—when will the virus curve peak? When will the economy start to recover? How bad will it get first? How long will the Fed keep the benchmark rate zero bound? How much will it grow its rapidly expanding balance sheet? With Phase 3 in the books and Phase 4 in the works, how many more phases will Congress and the White House push forward?

Pulling out the ’08-09 playbook

As we attempt to answer these questions, we’ve pulled out our playbook from the 2008-09 global financial crisis, which we entered with underweights across the credit complex and tactically shifted to overweights on signs that crisis was abating. This active management process proved beneficial over the course of the subsequent recovery and expansion, with our credit and duration positioning providing significant sources of alpha.

While we realize no two crises are exactly alike, we would anticipate making similar adjustments in the months ahead.

Tags Coronavirus . Fixed Income . Markets/Economy . Interest Rates . Volatility . Active Management .

Views are as of the date above and are subject to change based on market conditions and other factors. These views should not be construed as a recommendation for any specific security or sector.

Past performance is no guarantee of future results.

Alpha: This measures a fund's risk-adjusted performance. It represents the difference between a fund's actual returns and its expected performance, given its level of risk as measured by beta (see definition of Beta). This difference is expressed as an annualized percentage.

Bloomberg Barclays Government Index: A market value weighted index of U.S. government and government agency securities (other than mortgage securities) with maturities of one year or more. Indexes are unmanaged and investments cannot be made in an index.

Bloomberg Barclays US Corporate High Yield 2% Issuer Capped Index: The 2% Issuer Cap component of the US Corporate High Yield Bond Index. Bloomberg Barclays US Corporate High Yield Bond Index is an unmanaged index which measures the USD-denominated, high yield, fixed-rate corporate bond market. The index follows the same rules as the uncapped version, but limits the exposure of each issuer to 2% of the total market value and redistributes any excess market value index wide on a pro rata basis. The index was created in 2002, with history backfilled to January 1, 1993. Indexes are unmanaged and investments cannot be made in an index.

Bond prices are sensitive to changes in interest rates, and a rise in interest rates can cause a decline in their prices.

Diversification and asset allocation do not assure a profit nor protect against loss.

Duration is a measure of a security's price sensitivity to changes in interest rates. Securities with longer durations are more sensitive to changes in interest rates than securities of shorter durations.

High-yield, lower-rated securities generally entail greater market, credit/default and liquidity risks and may be more volatile than investment-grade securities.

International investing involves special risks including currency risk, increased volatility, political risks, and differences in auditing and other financial standards. Prices of emerging-market and frontier-market securities can be significantly more volatile than the prices of securities in developed countries, and currency risk and political risks are accentuated in emerging markets.

The value of some mortgage-backed securities may be particularly sensitive to changes in prevailing interest rates, and although the securities are generally supported by some form of government or private insurance, there is no assurance that private guarantors or insurers will meet their obligations.

Federated Investment Management Company