Thus far in 2019, the Fixed Income markets have seen a major tightening of credit spreads across the entire credit spectrum as rational minds prevailed following the fear-driven sell off in 4Q18. As a reminder, the credit spread is the incremental yield an investor demands on a corporate bond versus a Treasury bond of the same maturity. The more risky the debt of a company, the larger the credit spread. Additionally, interest rates further declined in 1Q19 as the Federal Reserve lowered to zero the number of expected interest rate increases in 2019 as compared to its previous expectations of two rate hikes. Given the limited upside of owning most fixed income securities, we constantly assess the fear meter. When the fear meter is high, we evaluate the economic situation and decide where to play offense. It is important to remember that in almost every economic outlook conceivable, there are always fixed income opportunities (yes, even in 2008). When the fear meter gets close to zero like it is now, wisdom dictates we patiently wait to pounce.
Currently, the risk meter is approaching record low levels as can be seen by the Investment Grade and High Yield Corporate credit spreads below. In times like these, we selectively pick our spots to play offense, while elsewhere taking the best opportunities the market provides. We know higher credit spreads will present themselves at some point, so we choose to accept a moderate return in the near term rather than try to be heroes and chase returns. Chasing returns generally leads to regret and hesitation when the fear meter rises again. We believe this approach offers much more attractive returns over the long-term.
Source: ICE Benchmark Administration Limited (IBA), retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/BAMLH0A0HYM2, March 27, 2019.
During the first quarter, interest rates declined led by the 10-year Treasury falling rather sharply to approximately 2.4% before more recently starting to rise. Credit spreads continued to significantly tighten across the credit spectrum, especially in high yield. While high yield outperformed in 1Q19, when looking at 4Q18 and 1Q19 combined, investment grade outperformed. This divergence in performance highlights the importance of active management and discipline. The ability to capitalize upon market dislocations, but also to be disciplined enough not to chase yield, can significantly add total return to a fixed income portfolio. Additionally, high yield underperforming for the six-month period suggests two important observations. First, the market is beginning to better distinguish stronger credits from weaker credits, and secondly, the market realized that high yield credit spreads were too narrow. Many fixed income investors were chasing yield without proper regard for risk. Overall, taking an incremental dollar of risk offered too little incremental return for a disciplined investor to justify going too far down the credit spectrum.
Looking towards the rest of 2019, the Fed has made it clear that interest rate decisions will be data dependent. Currently, the economic data remains relatively strong and the outlook for slower, but still healthy, growth remains intact for 2019. GDP growth has been moderate—in the 2-3%+ range for the past several quarters—and is expected by the Fed to be 2.1% in 2019 and 1.9% in 2020. Also, Core PCE inflation has recently remained below—although relatively close to—the Fed’s 2.0% target after several years well below 2.0%. Correspondingly, wage growth has been gaining momentum, above 3% in the six most recent reports, as a very tight labor market pushed the unemployment rate down to 3.8%. The Fed expects to see the unemployment rate remain low and even decline slightly through 2019, which may accelerate wage-based inflation pressures. If the economy remains strong and inflation perhaps increases, the Fed will likely consider raising interest rates later in 2019 and/or 2020. Even using the market’s implied base case of no Fed interest rate hikes in 2019, duration simply doesn’t pay right now with the spread between the 2-year and 10-year Treasurys at less than 0.2%. Additionally, longer dated bonds have significantly more credit risk should economic fears or a market panic occur like the one witnessed in 4Q18.
We remain focused on keeping maturities relatively short, credit quality relatively high, and duration low by maintaining a healthy exposure to floating rate notes. Additionally, we look forward to taking advantage of market dislocations to reposition selectively into securities that present very compelling risk/reward opportunities. We best describe our current positioning as relatively defensive as we wait to pounce the next time the fixed income market irrationally panics.