Entering 2020, consensus expectations were for low single-digit returns in fixed income with strategists anticipating the economy to slow and the FOMC to continue a gradual reduction in interest rates. Since March, when the COVID-19 pandemic began to rage across the globe, there have been close to 600 global stimulus actions to help spur economic activity. The FOMC has reduced rates to essentially zero and indicated this zero-bound will continue for a few more years until the economy can achieve full employment and reach 2% inflation. They have also indicated that they would allow inflation to moderately rise above 2% for a time before beginning another tightening cycle. These unprecedented actions have helped to fuel a substantial investor flow into fixed income assets while generating impressive returns. We provide a roundup of the major segments of the fixed income market below.
US Treasury
Yields on US Treasuries were stagnant for most of the 3rd quarter before long rates started to rise near the end of September, which resulted in negative returns for longer maturities. The 30-year US Treasury returned -0.76% while the 2-year US Treasury returned 0.08%. As the table below illustrates, one of the best performing asset classes within fixed income this year is US Treasuries. Much of this return has been duration dependent. Longer maturity bonds have outperformed shorter maturity bonds as interest rates have declined and reached historic lows. The 30-year US Treasury has returned 24% this year compared to the 2-year US Treasury’s return of 3%. We believe these historically low yields provide very limited future performance potential.
Investment Grade Credit
The virus caused an upheaval in the corporate bond market as the spread on investment grade corporate bonds widened close to 400 basis points in March. The Federal Reserve came to the rescue with both the primary and secondary market credit facilities that helped ease fears. Spreads have continued to tighten since March, and this trend continued through the 3rd quarter with the spread on the Bank of America Merrill Lynch Corporate Bond Index tightening by 21 basis points and ending the quarter at 134 basis points. This tightening helped to generate a total return of 1.20%. More impressively, the index has returned 6.5% for the year. New issue supply has been robust as corporations have issued record amounts of debt in this low-yield, high-demand environment. As the cumulative total return table shown below, returns have been bifurcated along credit quality and maturity. We added to this sector in the quarter and prefer the incremental yield pickup over US Treasuries. Credit quality remains strong; net leverage has decreased with larger cash positions on company balance sheets. We would look to add additional exposure if spreads were to widen.
Municipal Bonds
The municipal market has become expensive since the beginning of the pandemic. While yields initially widened relative to the treasury market since the Federal Reserve’s actions in the spring, yields have reversed their course and ended the 3rd quarter at historically low rates. On a year-to-date basis, the muni index is up 3.15%, with the strongest performance from the AAA rated space, up 4.17% and the 7-12-year part of the muni curve, up 3.33%. General obligation bonds have outperformed revenue bonds so far this year, up 3.64% compared to 2.98%. In the new issuance market, taxable issuance has dominated the space with issuance up nearly 3x compared to last year, while tax-exempt new issuance is down 1% compared to the prior year.
Last week, Moody’s Ratings Agency downgraded both New York State and New York City general obligation bonds by one notch to Aa2 based on ongoing economic concerns that the impact from the coronavirus has had and will continue to have on the issuers. For both issuers, this was the first downgrade in about three decades. From a headline perspective, this downgrade caught attention widely; however, in trading, there was little to no change as markets had previously priced in weaker yields as more news about the pandemic was disseminated. New York City accessed the debt markets this week and sold an additional $1.2 billion in general obligation bonds, demonstrating that they can continue to access debt markets amid the weakness and ongoing concerns.
Mortgage-Back Securities (MBS)
Spreads on the Bloomberg Barclays MBS Index declined 9 basis points on the quarter while generating a total return of 0.10%. Our exposure is predominately in 10- and 15-year final maturity pass-through securities where the overall returns are dependent on coupon and maturity selection. We prefer to invest in these shorter maturity (versus 20- and 30-year) securities to limit possible extension risk in the event interest rates were to rise.
Opportunistic Fixed Income
As a diversifier, we have maintained current positions in actively managed pooled investment vehicles in high yield, bank loans and dollar-denominated emerging market debt. All had positive total returns in the quarter of 4.2%, 3.2% and 2.7%, respectively.
Outlook for 4th Quarter
Volatility may increase in the 4th quarter on events surrounding the presidential election and expected increase in COVID-19 cases. We would look to increase allocations to investment grade corporate bonds and bank loans on any additional spread widening while maintaining a neutral posture in duration.