What market conditions had a direct impact on the bond market this quarter?
U.S. and global economies plunged in March as countries began instituting quarantine measures to contain the spread of COVID-19. The magnitude of the sudden stop in activity is unprecedented with some analysts predicting a quarter-over-quarter 25-35% annualized drop in Gross Domestic Product (GDP). The Federal Reserve (Fed) and fiscal authorities have reacted quickly and implemented massive stimulus programs to counter the expected decline in growth.
Economic Activity - Perhaps the most positive aspect of the U.S. economy was its relative strength coming into March. Q4/19 U.S. GDP grew at an annualized 2.1% pace and employment conditions were robust with a low 3.5% U3 Unemployment Rate (U3) in February. Unfortunately, most economic data prior to late March is hopelessly out-of-date and offers no real insight into the trajectory of the economy. Perhaps the best real-time economic indicator is Initial Jobless Claims which showed 16.78 million in new claims over the three weeks ending April 3rd. For context, the March 6th claims number was 211,000, near 50-year lows. Some analyst forecasts suggest U3 could reach 15-20%, well above the 2009 10% peak during the Great Financial Crisis (GFC). Adding to the economic decline during the quarter, oil producing countries could not come to an agreement on oil production cuts at a time when demand is expected to collapse. The swift decline in crude oil prices and increase in oil inventories lead to rapid decrease in U.S. oil production and rig counts. March manufacturing and data had not begun to fully reflect the expected declines in production, but March's Empire Manufacturing -21.5 print is a harbinger of the inevitable. Not surprising, inflation expectations have fallen below 1% despite the massive increase in fiscal and monetary stimulus. Unfortunately, stimulus measures can support economic activity and financial markets to a certain point as an economic recovery is dependent on medical remedies for COVID-19 and a reopening of social and business activity.
Monetary Policy - The Fed acted swiftly to bolster the economy and provide liquidity to the financial markets with both broad policy actions and more targeted credit and liquidity facilities (see below). The Fed has been far more proactive implementing policy initiatives than during the GFC, when perceptions of Wall Street malfeasance presented moral hazard questions around both monetary and fiscal responses.
Broad Policy Initiatives
Policy Rate Cuts - Reduction in federal funds target range designed to ease financial conditions
- 150 basis points (bps) in two separate emergency meetings
- Policy rates are essentially at the zero bound
Quantitative Easing - Treasury and agency purchases designed to ease financial conditions
- Fed is committed to making unlimited asset purchases across the yield curve
- "Securities Held Outright" on Fed's balance sheet has grown $1.248 trillion (from $3.848 trillion on February 26th to $5.096 trillion on April 8th)
Liquidity and Funding Policies
- Increased Foreign Central Bank Swap Lines and repo programs to provide dollar funding to foreign central banks
- Banks are openly encouraged to use the Discount Window as a source of funding to support flow of credit
- Temporarily modify the growth restriction on Wells Fargo to accommodate increased lending through the Paycheck Protection Program
- Temporarily lowered the community bank leverage ratio to 8%
Targeted Liquidity Facilities
Primary Dealer Credit Facility (PDCF)
- Provides term funding for primary dealers for collateral including investment-grade corporates / commercial paper / Municipals / Asset- Backed Securities (ABS) debt / equities
Money Market Liquidity Facility (MMLF)
- Provides liquidity relief to prime and tax-free money market funds while also improving market functioning
Commercial Paper Funding Facility (CPFF)
- Provides a funding backstop to facilitate the issuance of term commercial paper for certain U.S. companies
Primary Market Corporate Credit Facility (PMCCF)
- Provides bridge funding to investment-grade companies for up to four years by selling directly to the PMCCF
Secondary Market Corporate Credit Facility (SMCFF)
- Provides market liquidity through the purchase of outstanding investment-grade corporate bonds and Exchange-Traded Funds
Term Asset-Backed Securities Loan Facility (TALF)
- Facilitates the issuance of asset-backed securities collateralized by consumer loans (cards, auto, student, Small Business Administration (SBA)
Fiscal Policy - The primary fiscal response to the COVID-19 crisis was the Coronavirus Aid, Relief and Economic Security (CARES) Act, which was passed into law on March 27th. Key features of the CARES Act include:
Household Income Assistance
- $300 billion for direct cash payments of $1,200 for single filers with income below $75k / $150k married, phased out for higher earners
- $260 billion for expanded unemployment insurance
- Additional unemployment insurance of $600 per week for up to 16 weeks
- Expanded eligibility for individuals
Small Business Assistance
- $349 billion for Payroll Protection Program - SBA administered loans entities that meet certain requirements, with a key requirement being maintaining employment at 90% plus of pre-COVID-19 levels.
- $27 billion in emergency grants to support existing SBA loans
Additional Business / Municipality Assistance
- $454 billion in capital for the Exchange Stabilization Fund to support various Fed programs and facilities
- $25 billion in loans for passenger air carriers / $4 billion in loans for cargo air carriers / $17 billion in loans for businesses critical to maintaining national defense
- $100 billion fund to support eligible healthcare providers
- Deferral of employer payroll tax payments through 2020 - potentially freeing up $350 billion of liquidity
- A rapid decline in U.S. Treasury yields, dramatically wider credit spreads and illiquidity dominated the credit markets in March. Positive price performance from lower U.S. Treasury yields was more than offset by the negative price impact of wider spreads, particularly for lower-quality issuers and indexes. The damage to risk assets was reflected in equity levels where, peak-to-trough, the S&P 500 and NASDAQ declined 34.0% and 30.1% respectively. After reaching $14.9 trillion in market value on March 9th
, the Barclays Global Aggregate Negative Yielding Debt index ended the quarter at $10.6 trillion. Unlike previous periods where the decline was driven by improving global growth prospects, March's decline was driven by increased credit concerns. One bright spot for credit conditions was the robust primary market for investment-grade debt, which set records for monthly and quarterly issuance. A significant portion of new issuance was focused on debt with tenors of 10 years and longer, which was met with strong demand from pensions and life insurance companies in need of both duration and yield.
Yield Curve Shift
The 3-month to 10-year and 2-year to 10-year portion of the yield curve steepened by 23.5 and 7.6 bps respectively in the quarter, although the information value of a steeper yield curve has diminished considerably.
Duration Relative Performance
*Duration estimate is as of 3/31/2020
U.S. Treasury indexes were strong performers in the first quarter, as yields fell on a combination of 150 bps of Fed rate cuts in March, the steep decline in economic activity and the Fed's asset purchase programs. As expected, long duration strategies and indexes strongly outperformed their shorter duration counterparts. The duration of U.S. Treasury indexes declined slightly vs. last quarter as the composition of net new issuance skewed toward shorter duration instruments, T-bills in particular.
Credit Spread Changes
Corporate credit spreads blew out in the quarter on a combination of a deteriorating economic outlook and a dislocation in financial market liquidity. Significant outflows from long-term bond funds of multiple asset classes resulted in asset sales which were met with limited demand from investors focusing on liquidity, resulting in bloated dealer balance sheets, wide bid-ask spreads and deteriorating asset prices. The liquidity dislocation peaked around March 20-23 when the 1 - 3 A and BBB-rated Corporate and Yankee indexes' OAS spreads topped out at 355 and 552 bps respectively. The Fed's massive quantitative easing program, along with more targeted liquidity facilities helped reduce dealer inventories and supported investor confidence, allowing spreads to tighten toward quarter-end.
Credit Sector Relative Performance of ICE BofA Indexes
Not surprisingly, higher-quality credit strongly outperformed lower-rated counterparts. Industries such as leisure, airlines and autos were hit particularly hard by COVID-19 and the associated shutdown in economic activity. Financials outperformed non-financials by 55.8 bps. The general perception is banks are far stronger fundamentally coming into this crisis than during the GFC.
What strategic moves were made and why?
Taxable Portfolios - Credit spreads widened significantly in March, negatively impacting performance of all spread product vs. Treasuries. The damage crossed all asset classes with lower quality debt and issuers dramatically underperforming higher-quality counterparts. U.S. Treasury yield curve levels fell in concert with the 150 bps of Fed rate cuts in March. Corporate floating-rate note (FRN) performance suffered more than their fixed-rate counterparts, as FRNs bear the entire effect of wider credit spreads without the partial offset of falling U.S. Treasury yields. Market liquidity deteriorated in March, driven in general by a flight-to-quality investor mentality and, more specifically, a supply / demand dislocation caused by long-fund withdrawals where fund managers were forced to liquidate positions with few natural buyers. Massive Fed liquidity programs, including quantitative easing and more targeted facilities, partially eased liquidity pressures in late March and into the second quarter. Issuer public ratings came under considerable pressure with few industries spared from negative actions.
Tax Exempt and Tax-Efficient Portfolios - Coronavirus implications for the municipal market were decidedly negative as states and local governments stared down slowing economic growth and rising expenses. Weekly redemptions from municipal bond funds set new records and triggered sharp market dislocations. Our mindset during this time was centered on individual client situations and objectives. For some accounts, we looked to selectively add duration. We focused on larger, AA or better rated issuers with flexibility to absorb short-term pressures. These extension trades are expected to be beneficial to income as the Fed will likely keep rates near the zero bound for some time. We also had accounts that preferred to stay on hold for different reasons. Variable-rate demand notes (VRDNs) presented a compelling opportunity. In the closing weeks of the quarter, rates on these securities spiked to more than 5%. VRDNs offered an attractive mix of income, price stability and liquidity in an otherwise volatile environment.
How are you planning on positioning portfolios going forward?
Taxable Portfolios - With current corporate, bank and ABS positions marked at wider spreads, the most likely driver of performance going forward will be a recovery in credit spreads driven by Fed liquidity programs or the natural convergence toward par as securities season over time. We will continue to add corporate exposure to portfolios at these more attractive spread levels, placing an emphasis on higher-quality companies with strong balance sheets and the cash generation capacity to manage this challenging environment. Further, we anticipate negative rating agency actions will continue for the foreseeable future and in turn will focus on purchasing credits with a ratings cushion above individual client investment policy minimum criteria. While we believe our current holdings do not represent a threat to principal, meaningful downgrades can impact issuer liquidity and bid / ask spreads. Avoiding forced sells in a challenged market is a key tactic to preserving principal and providing excess returns in coming quarters. We are taking a cautious approach to adding further exposure to consumer ABS. We remain confident in our approved AAA-rated ABS traunches and structures, but the converging pressures of high unemployment, declining incomes and auto company stress argue in favor of a conservative approach to the sector. We prefer to monitor the impact of these negative pressures on underlying asset performance before adding additional exposure. From a duration standpoint, we expect the Fed to remain on hold for the foreseeable future, which limits the risk of a policy-induced U.S. Treasury sell-off. With so much dislocation across all sectors and the anticipated massive amount of U.S. Treasury and corporate issuance in the pipeline, we expect there will be tactical opportunities to add duration in both government and corporate debt. While the Fed's programs have improved market functioning to some extent, market liquidity should be viewed as variable at best. Accordingly, our investment strategy for managing known portfolio withdrawals will emphasize match-funding over portfolio sales when possible.
Tax Exempt and Tax-Efficient Portfolios
- Municipalities are entering a challenging period and security selection will be paramount to successful strategies. Our credit team will look toward issuers with greater reserve levels and financial flexibility to better navigate budget shortfalls. We will also be mindful of concentrations in revenue sources and employment industries most sensitive to the pandemic. As ratings downgrades continue to loom, we believe investment-grade municipal bonds can remain among the highest regarded fixed income sectors. In recent weeks, municipalities have received substantial support from both the CARES act and the Federal Reserve's Municipal Liquidity Facility (Facility). These programs have been somewhat helpful in stabilizing fund flows and restoring confidence. We will be closely monitoring the effectiveness of the Facility as it is rolled out in coming weeks and pricing details are revealed. The potential for a surge in short-term debt issuance is a threat to monitor. Still, given the expectation for a low-interest rate environment, we would likely view increases in yields as an opportunity to extend durations. VRDN pressures have resolved and these rates are moving swiftly toward zero. Our preference will be for fixed-rate securities to secure higher income levels.
U.S. Department of Treasury