What market conditions had a direct impact on the bond market this quarter?
During the quarter, corporate spreads and risk assets continued to perform well as investors maintained a generally positive tone. The inability of Congress to pass healthcare legislation increased uncertainty over the timing and magnitude of promised fiscal and regulatory reforms, leaving markets vulnerable at current valuations.
Economic Activity - First quarter U.S. GDP growth forecasts are in line with Q4/16's 2.1% rate. Employment conditions continued to improve, illustrated by the quarterly decline in U3 Unemployment rate to 4.5% from 4.7% and the corresponding decline in the U6 Underemployment Rate (which includes the total unemployed, plus all persons marginally attached to the labor force, plus total employed part-time for economic reasons) to 8.9% from 9.2%. Non-Farm payrolls added 533,000 jobs in the quarter despite the disappointing - and likely weather impacted - March addition of only 98,000 jobs. Household Employment outperformed Non-farm Payrolls by adding 889,000 jobs in the quarter. In another sign of employment strength, 561,000 people entered the Labor Force, improving the Labor Participation Rate to 63.0% from December's 62.7%. The climb in Labor Participation makes the decline in unemployment rates even more impressive, as it was clearly driven by an increase in the number of people employed rather than a reduction in the work force. U.S. Weekly Initial Jobless Claims - a helpful real-time indicator of employment conditions - averaged 246,000 in the quarter, a level last seen in the early 1970s. Consumer and Small Business Confidence remained at elevated post-election levels on increased hopes for lower taxes and reduced regulatory burdens. The year-over-year (yoy) Consumer Price Index reached 2.7% in February. The increase is primarily driven by the increase in oil and gas prices vs. last year's depressed energy levels. February's U.S. Personal Consumption Expenditure Core Index rose a milder 1.8% yoy. Given the consistent strength in employment conditions and a noticeable lack of broad sector bubbles in the real economy, the risk of a near term recession is low.
Credit Markets - Credit spreads benefitted from the investor optimism and risk-on bias prevalent since the November elections. The option-adjusted spread of the BofA Merrill Lynch 1-3 Year AAA-A U.S. Corporate Index tightened from 70 basis points (bps) to 61 bps over the quarter, adding additional return to the index's incremental coupon income. Corporate issuers took advantage of strong investor demand for spread product, printing $579B of term debt in the quarter - up 12.6% from last year's levels. Secondary market liquidity remained solid as markets were relatively calm during the quarter.
*Corporate index outperformed the Treasury index by 34 bps in the quarter
The public rating environment for AAA- to A-rated bank and corporate credit remained relatively benign, although headline risk did touch high-quality issuers such as Reckitt Benckiser and Unilever.
*Long index outperformed the short index by 11.2 bps in the quarter
The yield curve flattened in the quarter as short rates rose with the Federal Reserve (Fed) rate hike, while longer yields were relatively stable as investors began reducing their expectations for fiscal policy stimulus. In the quarter, one-year Treasury yields rose 20.6 bps while five-year yields actually fell by 0.6 bps, leading longer duration indexes to outperform their shorter counterparts.
Monetary Policy - The Fed raised its target rate 25 bps at the March 15th meeting. The Fed's Dot Plot forecast remained essentially unchanged, with median forecasts calling for two additional 25 bp rate hikes in 2017 and three more in 2018. The accompanying statement was little changed from December, with no indication the Fed felt it was falling behind in controlling inflation and inflationary expectations. The Fed's economic forecast was biased slightly upward from December and the Fed noted continued progress on meeting its employment and inflation goals. While policymakers are cognizant of the potential lift from fiscal policy, most appeared unwilling to alter their forecasts until more details are known on fiscal policy stimulus. Regarding the Fed's balance sheet, the minutes from the March 15th meeting revealed officials "judged that a change to the Committee's re-investment policy would be appropriate later this year." Given this guidance, our base case path would be a tapering of monthly re-investments after further rate hikes, with an announcement in late 2017 and implementation in 2018.
Fiscal Policy - The promise of tax cuts and fiscal policy changes rather than their actual enactment drove markets in the quarter. Republican ineffectiveness over the Affordable Care Act's repeal and replacement has increased investor concern about Washington's ability to enact meaningful and effective tax, infrastructure and regulatory legislation. President Trump has been more successful with targeted initiatives such as approving the Keystone pipeline and celebrating corporate investment in new plants and equipment - both of which can be done outside of the legislative process and can positively impact investor and business confidence. However, financial markets appear vulnerable should proposed fiscal stimulus and regulatory reforms not match expectations priced into current valuations.
What strategic moves were made and why?
Taxable Portfolios - Credit markets enjoyed the continued tailwinds of improved investor confidence and steady economic growth, all despite the pronounced speculation around both fiscal and monetary policy. As a result, spread product tightened and the yield curve flattened as short rates rose in sympathy with the Fed rate hikes. Our core strategy of increasing portfolio income by emphasizing spread product remained in place and enjoyed additional return through the tightening of credit spreads. As expected, the risks to credit markets were more issuer specific than macro related - a trend we expect to continue and to manage through issuer and sector diversification. Portfolio duration was targeted to be short to benchmark duration, particularly for portfolios with duration targets of over one year. Shorter portfolios were closer to benchmark durations, as the lingering effects of money market reform pushed commercial paper (CP), certificates of deposit (CD) and LIBOR rates higher, making short paper and floating-rate notes a more attractive investment option by historical standards.
Tax Exempt and Tax-Efficient Portfolios - Short-term municipal bonds out-performed most other fixed-income alternatives during the quarter, with yields on one- to five-year AAA-rated maturities declining between 11 and 27 bps. Muni issuance was limited, most notably in February and March. Political uncertainty around issues that could potentially impact state and local government budgets (i.e., healthcare reform) may have played a part in issuers being more cautious with funding new projects. Investors, too, have reasons to be cautious and may be parking cash reinvestments in shorter maturities for the time being. While it appears there may be some delay on tax-reform policy, the prospects for eventual lower corporate -and possibly individual - tax rates still seem to be good. For tax-efficient accounts, we have added to corporate bond allocations during the last few months. With comparable taxable equivalent yields at current tax rates, we believe this is a prudent strategy. Variable-rate demand note (VRDN) resets moved higher following March's federal funds rate increase. We were active buyers of these securities across accounts, with yields averaging 91 bps at quarter end as indicated by SIFMA.
How are you planning on positioning portfolios going forward?
Taxable Portfolios - We expect the Fed to lift rates two more times in 2017, although the exact timing is subject to the ability of Washington to enact fiscal and regulatory reforms. Regardless of the timing, we believe the short end of the yield curve - five years and in - will be higher by year end, leading us to continue our overall short duration strategy. The degree of "shortness" will be adjusted by individual portfolio duration limits, with shorter duration portfolios likely closer to benchmark durations than their longer duration counterparts. For all strategies, we will strive to position portfolios to more rapidly react to anticipated Fed rate hikes. LIBOR-based floating-rate notes, CP and CDs will continue to play a prominent role in portfolio construction in order to accomplish this goal. To achieve our core strategy of emphasizing coupon income, we continue to emphasize portfolio exposure to corporate, bank and asset-backed security credits. While the market is in the latter stages of the credit cycle with credit quality deteriorating around the edges, the risk / return relationship for spread product in the investment-grade, five-year and in space remains attractive. We view financial debt as particularly attractive based on wider spreads and lower event risk vs. their industrial counterparts.
Tax Exempt and Tax-Efficient Portfolios - As of March 31st, the yield pick up on a three-year AAA-rated muni over VRDNs was less than 30 bps. With further federal funds rate hikes on the horizon - perhaps as soon as June - we are pressed to find value in longer municipal securities at this time. We expect VRDNs will continue to be utilized across portfolios and as reinvestments from bond maturities occur, these allocations may increase. For tax-efficient accounts, we will likely continue to use corporate bonds for the majority of our extension trades. We anticipate making progress toward positioning portfolio durations closer to 90% of benchmarks as available cash reinvestment allows.
Federal Reserve, Chair's FOMC Press Conference Projections Materials, March 15, 2017, (www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20170315)
Federal Reserve, Chair's FOMC Press Conference Projections Materials, December 14, 2016, (www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20161214)