Since the end of September, it’s been a wild ride by fixed income standards. In the first week of October, hawkish Powell comments combined with a strong employment report amplified market volatility. In the first week of October, the 10-year Treasury rose 17bps (basis points) from 3.06% to 3.23% and the 2-year Treasury rose 7bps from 2.82% to 2.89%, while stocks remained relatively flat. This was just the beginning of increased volatility across all markets. During periods of market volatility, some investors panic, while most investors just hold on tight and do nothing. However, these periods allow active managers to distinguish themselves by taking advantage of select opportunities. These opportunities can be especially compelling in fixed income where the upside, downside, and timeline can be identified more readily than in equities.
Investors grew increasingly concerned in 4Q that the Federal Reserve would continue to raise rates based on excessive inflation concerns, rather than behaving in a fully data dependent manner. Simultaneously, select regions of the global economy began to show definite signs of slowing growth while other regions indicated potential weakness. This increased the risk premium across all asset classes. These two factors caused credit spreads to widen dramatically across both investment grade and high yield bonds and preferreds (preferred equity shares). Correspondingly, when investors seek safe haven assets they flock to Treasury bonds, which depresses medium and long-term interest rates.
During periods of increased market volatility, the increase in credit spreads typically more than offsets the decline in Treasury interest rates. This phenomenon proved especially true in 4Q’18. Starting in late September, credit spreads widened across investment grade, high yield, and preferreds as risk premiums increased. Select bonds and preferreds, especially those rated BBB or below traded at bargain prices. Normally, such bonds and preferreds trade at small yield premiums which are not overly attractive. But the overall market volatility created emotional selling. For example, select investment grade bonds and preferreds—those likely to be called in less than four years—offered yields of 5.5%-6.5% or higher. This should have had fixed income investors salivating, not panicking. Such lucrative opportunities are rarely available in a calm market. Additionally, almost the entire high yield sector sold off in unison, providing investors opportunities to buy select bonds at relatively high yields.
During 4Q’18, many exchange-traded preferreds, partially due to their retail investor (nonprofessional) base, sold off more than 6%, which presented select opportunities to buy them at extremely enticing yields. Exchange-traded preferreds trade like stocks over an exchange unlike traditional bonds, which trade over the counter. Exchange-traded preferreds are typically traded in $25 increments rather than $1,000 increments which make them more retail-investor friendly. The retail investor base makes these securities more likely to display significant volatility which can create more opportunity for an active manager. (Just to be clear, exchange-traded preferreds are not the same thing as exchange-traded funds, or ETFs.)
Since peaking in late December, credit spreads have narrowed dramatically: spreads tightened, on average, by approximately 60-80% of the Q4 increase. Interest rate expectations have also reversed course since the early October spike, as the Fed emphasized its data dependency. The yield on the
2-year Treasury bond peaked at 2.92% in early November and has since declined to 2.46%. The 10-year Treasury yield has experienced a more dramatic decline from around 3.25% in early October to the current level of 2.63%. The overall effect of significantly lower interest rates and only somewhat wider credit spreads (versus the end of September) has resulted in lower yields. The graph below illustrates the dramatic increase and subsequent decline in investment grade and high yield credit spreads. While volatile markets create tremendous opportunity, investors must actively seize such opportunities because the bounce back can occur just as quickly.
Investors should remember that volatility typically creates panic. Panic prompts some investors to sell near the bottom while simultaneously providing others with tremendous opportunity. A rational, calm investor is able to seize compelling opportunities while others are fearful. For this reason, we prefer owning a high quality, relatively liquid fixed income portfolio while employing an unconstrained approach. An unconstrained approach and active portfolio management provide maximum flexibility to enhance returns whenever market dislocations occur.