After a very volatile end to the year in 2016, the first quarter of 2017 saw a much more benign movement in interest rates and corporate bond yields as most fixed income markets stabilized after a difficult fourth quarter. During the first quarter of 2017, Treasury yields traded within a fairly narrow, 24 bps range. The movements in Treasury yields were generally lower as the 10 Year Treasury yield began the quarter at 2.45% and ended it at 2.39%. Accompanying the lower yields in Treasuries, corporate credit spreads continued their persistent grind tighter that began in mid‐ February of 2016 and ended the quarter near the tightest levels of the past 13 months. Specifically, the A Rated Corporate credit spread tightened from 1.01% to 0.97% (down 4 basis points (bps)) and the BBB Rated Corporate credit spread tightened from 1.60% to 1.51% (down 9bps)i. When looking at the movement of interest rates and credit spreads together, the decline in Treasury yields and slightly tighter corporate credit spreads helped Investment Grade corporate bond yields end the quarter slightly lower than where they started. While both US Treasuries and Investment Grade corporate bonds both ended the quarter with lower yields, thus both achieving positive performance, Investment Grade corporate bonds outperformed Treasuries due to the tightening of credit spreads and higher coupon income collected. The Barclays US Investment Grade Corporate Index returned +1.22% for the quarter, outperforming the Barclays US Treasury 5‐10 year index return of +0.89%ii. The CAM Investment Grade Corporate Bond composite provided a gross total return of +1.37% which outperformed both of the above mentioned indices.
The beginning of the year saw robust demand for US Investment Grade corporate bonds which allowed for a record setting new issuance in the quarter. During the quarter there was $413B of new issuance across 565 issues which represented a 14% increase from Q1 2016iii. A large portion of the new issuance were bonds with 5 and 10 year maturities ‐ an area of interest for CAM. As an institutional investor who participates in the primary (new issuance) marketplace, we were able to be fairly active in Q1, which has benefits to our clients. According to CreditSights, the average yield pickup in the new issue market for 10yr Investment Grade Corporate Bonds in the first quarter was 10bps, or 0.10% in additional yield, versus comparable bonds of the same issuer in the secondary marketiv. We will continue to participate in the primary market when there are attractive opportunities in credits we like.
The first quarter was also marked by policy action by the Federal Open Market Committee (FOMC) at their March meeting. While CAM has always considered itself interest rate agnostic in its investment process, we think it makes sense to clarify what the FOMC has been doing and its effects on the yield curve as it relates to our portfolios. The FOMC sets interest rate policy for very short‐term interest rates by influencing the Federal Funds rate, the overnight lending rate between banks. One way this is done is through adjusting the reserve requirements of member banks with The Federal Reserve. The FOMC sets a target rate that is, effectively, what most think of when one hears that the Fed “raised rates” or “lowered rates”. This in no way directly affects interest rates for other, longer dated maturity bonds. Those interest rates are determined by investors’ inflation forecasts, which can be impacted by FOMC activities. So, interest rate policy indirectly affects yields on longer dated fixed income securities. It may be surprising what this impact has been since the FOMC has been hiking the target Federal Funds rate in this cycle. As an investor in the intermediate portion of the yield curve (5 – 10 year maturities), we will examine the 10 year part of the Treasury curve to analyze those interest rate movements around the recent FOMC policy actions.
The FOMC began their recent increase in monetary policy on December 16, 2015 by hiking the Federal Funds target rate by 25 bps or 0.25%v. This was their first “rate hike” in over a decade. The day they made this policy announcement the yield on the 10yr US Treasury was 2.30% (see graph)vi. The immediate effect on this yield was opposite of what most market commentators and investors thought as it began a sharp decline all the way to a low of 1.37% on July 5, 2016.
The next FOMC policy action came a year later on 12/14/16 when they announced a hike in the target rate by another 25bpsvii. At the time of this announcement the yield on the 10yr US Treasury was back up to 2.54%. The reaction to this policy move was again a decline in yield to a low on 2/24/17 of 2.31%. The FOMC’s most recent move, their third “rate hike” of 25bps saw the 10yr US Treasury yield at 2.51% which has since declined to 2.18% (as of 4/18/17)viii. In summary, since the FOMC began moving up their target range on the Federal Funds rate in December 2015 by a total of 75bps or 0.75%, the yield on the 10yr US Treasury has moved down from 2.30% to 2.18% with more downside volatility in between. We are not suggesting that this pattern will continue or that it is indicative of any future direction of interest rates. In fact if the FOMC were to begin unwinding their $4.5trillion balance sheet, as has been recently discussed by Janet Yellenix, they may directly affect this part of the yield curve by selling treasury and mortgage securities in the open market. Prior unconventional FOMC actions of quantitative easing (QE) directly affected longer term interest rates by lowering them through open market purchases of treasuries and mortgages. If any future unconventional FOMC policies were to unfold we will address those issues in future quarterly commentary or white papers available at www.cambonds.com. The point is that while investors are sometimes focused on the short term noise of the FOMC policy actions, the long term outcome can be different from what one expects. In addition to this decline in yields on 10yr US Treasuries, credit spreads have tightened considerably during this time, giving a boost to the performance of US Investment Grade Corporate Bonds. During this period of FOMC policy action of “rate hikes” the total return of US Investment Grade Corporate Bonds as measured by the Barclays IG Corporate Bond index has been in excess of +7.0%x. Clearly this type of return was not expected by many when the FOMC embarked on this “rate hike” cycle, and should not be expected to continue in the future, but has rewarded those investors who stayed the course and were not led to exit corporate bonds because the FOMC was “raising rates”.
We remind our clients that corporate bond investors are compensated for two risks; interest rate risk and credit risk. The first, interest rate risk, is approximated by US Treasury yields as described above. The second, credit risk, is the remuneration for the business risk of the underlying company; this remuneration is expressed as the premium received in excess of the US Treasury yield, more commonly known as the credit spread. In our experience, investors spend a large portion of their time focusing on the risk they can’t control ‐ interest rate risk, and very little time on the risk that can be controlled – credit risk. We as a manager believe that we can provide the most value in terms of assessing credit risk. In our view, the key to earning a positive return over the long‐term
is not dependent on the path of interest rates but a function of: (1) time (a horizon of at least 5 years), (2) an upward sloping yield curve ‐ to roll down the yield curve, and (3) avoiding credit events that result in permanent impairment of capital. Following this philosophy over time can help investors to ignore the short term noise of any FOMC policy actions and focus on what is truly important.
This information is intended solely to report on investment strategies identified by Cincinnati Asset Management. Opinions and estimates offered constitute our judgment and are subject to change without notice, as are statements of financial market trends, which are based on current market conditions. This material is not intended as an offer or solicitation to buy, hold or sell any financial instrument. Fixed income securities may be sensitive to prevailing interest rates. When rates rise the value generally declines. Past performance is not a guarantee of future results. Gross of advisory fee performance does not reflect the deduction of investment advisory fees. Our advisory fees are disclosed in Form ADV Part 2A. Accounts managed through brokerage firm programs usually will include additional fees. Returns are calculated monthly in U.S. dollars and include reinvestment of dividends and interest. The index is unmanaged and does not take into account fees, expenses, and transaction costs. It is shown for comparative purposes and is based on information generally available to the public from sources believed to be reliable. No representation is made to its accuracy or completeness.
i Barclay’s Credit Research: Daily Credit Call
ii Bloomberg Barclay’s Indices: Global Family of Indices March 2017
iii Dealogic & CreditSights, Strategy Analysis April 2017: US IG Issuance: Concessions Still Exist
iv Dealogic & CreditSights, Strategy Analysis April 2017: US IG Issuance: Concessions Still Exist
v FOMC statement dated 12/16/15 https://www.federalreserve.gov/newsevents/pressreleases/monetary20151216a.htm
vi FRED database https://fred.stlouisfed.org/series/DGS10
vii FOMC statement dated 12/14/16
viii FOMC statement dated 3/15/17
ix Bloomberg News April 30, 2017: “Fed’s Cut in Bond Holdings May Be Messier Than Yellen Hopes” x Bloomberg Barclay’s Indices: Global Family of Indices March 2017