Fixed Income Markets
The U.S. Treasury yield curve was relatively unchanged in the third quarter, leading to subdued but positive returns in the higher-quality, rate-sensitive areas of fixed income markets. The Barclays U.S. Treasury Index returned 0.1%, while the Barclays U.S. Aggregate Index returned 0.6%. On a year-to-date basis, however, returns have been quite strong due to the sharp decrease in yields.
Credit spreads, on the other hand, narrowed during the quarter and drove stronger returns in corporate and high-yield credit. U.S. investment grade corporate bonds returned 1.5%, while high yield returned 4.7%. However, on a year-to-date basis, high-yield bonds are still down 0.2%, while higher-quality investment grade bonds have returned 6.7%. Viewed over a longer period, high-yield credit spreads, at 5.2%, trade near their median level over the past 20 years. The default outlook, though, is much more uncertain. According to Moody’s, the trailing 12-month global speculative grade default rate was 6.4% at the end of September and is expected to peak at 8.4% in March 2021, well above the historical average, which is 4.1%2 While investors can buy a stated yield of over 5% in high yield, they do so with significant uncertainty around their future potential credit losses.
Though interest rates were relatively unchanged this quarter, the Federal Open Market Committee (FOMC) was still active in setting expectations about their future path. On August 27, the FOMC amended its “Statement on Longer-Run Goals and Monetary Policy Strategy,” where the committee outlined a new policy of average inflation targeting. This policy aims to let inflation run above its 2% target following periods when inflation has run persistently below this level. With inflation having persistently undershot the Fed’s 2% target since the global financial crisis, the Fed has given itself room to keep rates near zero even if inflation begins to creep up. If we take the Fed at its word, this new guidance, as well as the most recent FOMC projections that show 13 of 17 members projecting a 0% to 0.25% fed funds rate through the end of 2023, give significant support to the view that short-term interest rates will likely stay low for some time.
While the opportunity set in fixed income is not determined entirely by Fed policy – credit spreads and long-term interest rates are determined by myriad other factors – the forward-looking returns in fixed income at this point in time are relatively muted. Instead of reaching for returns, we recommend that investors remember that fixed income’s primary purpose is to provide stability and liquidity to portfolios. We will actively seek additional return and income-generating opportunities to complement our portfolios, but credit quality should not be sacrificed in the core of the fixed income portfolio.
As we look forward, we believe that it will be difficult to generate the same level of market returns that investors have earned historically. Declining interest rates, for one, have undoubtedly been a tailwind to both fixed income and equity returns, and if we take the Federal Reserve at its word, rates will likely stay low for the next few years. Meanwhile, the investment environment has only appeared to get more challenging, given COVID-19, the potential for a contested U.S. election and rising geopolitical tensions, to name a few. In this environment, we believe disciplined security selection will be critical to generating attractive long-term returns. Therefore, now more than ever, we believe that actively managed concentrated strategies offer the best chance to add value over long-term periods. While valuations have certainly become more expensive, particularly in certain sectors of the market, our managers are optimistic that they can generate compelling returns going forward by owning a concentrated portfolio of high-quality cash flowing companies that can compound capital over time. By design, our managers construct portfolios that look different from their benchmarks; thus, performance can and will diverge from market-level returns.
Above all, we recommend staying the course, sticking to your asset allocation and focusing on the long term. While there are admittedly many crosscurrents in the market today, market timing has never proved to be a repeatable investment strategy. A long time horizon and the patience to wait through periods of market turbulence have always served investors well.