It can be easy to forget that the “market consensus” is actually a weighted average of a wide range of views of the future. Even when events unfold along the consensus path, if the range of future outcomes narrows, markets will react. The two dominant market movements of the last quarter, the rapid back-up in Treasury rates of late March and the rally in credits subject to refinancing risk, are both helpful reminders of what a slightly narrower range of future expectations can do.

Throughout the first quarter, Treasury futures suggested a consensus view that short rates would start to rise in mid-2015. Longer rates rallied through the quarter until March 19th, when Janet Yellen made unscripted remarks suggesting that rate hikes could begin approximately six months after quantitative easing (QE) ends. Since QE is widely expected to end by the fourth quarter of this year, Yellen’s remarks literally confirmed the market consensus. Despite this, investors reacted negatively to these comments driving interest rates higher, particularly in short maturities. By the close on March 19th, the five-year Treasury Note yield spiked 16 basis points to 1.70% and the ten-year yield increased 10 basis points to 2.77%. In addition to demonstrating how changes in future uncertainty can drive market movements, this episode shows how exquisitely sensitive today’s very low rates are to small changes in future rate expectations.  With very little coupon to cushion investors in the period ahead, Treasuries could be more volatile.

Another pronounced theme is the continued improvement in credit trends and credit spreads. Most banks passed the latest round of Fed stress tests and lending is rising consistently. The huge opportunity investing in unsecured bank credit is largely behind us. In fact, for the first time in a long time, the performance of financials trailed other sectors of the corporate bond market. The market is still absorbing the secondary effects of banks and finance companies flush with inexpensive capital and ample reserves. Sectors such as REITS, CMBS, ABS, and more cyclical Industrial credit, where uncertainty about future refinancing is a major pricing variable, have taken over the credit rally leadership. The pace of refinancing commercial real estate debt in particular has accelerated, as property owners race to lock in ten-year loan financing in advance of higher rates. The more competitive financing environment for real estate and other commercial loans has increased the prices of structured product containing property and other forms of commercial credit. Prepayment of legacy CMBS loans picked up 125% in 2013, average net income improved across property types, and already low defaults at maturity were down over 50% compared to 2012. Once again, a reduction in the uncertainty related to future refinancing drove a rally in spreads in the most refinancing-sensitive sectors.

Finally, mergers continue to play a large role in the credit landscape and within our portfolios. With some companies experiencing constrained opportunities for organic or market growth, and with capital cheap and cash reserves plentiful, consolidation is in the air in several industries. We commented last quarter on the heightened leveraged merger risk in cable and telecom. During the quarter, Comcast agreed to buy Time Warner Cable for stock, blocking a leveraged acquisition offer from Charter Communications. This transaction, which might still face government opposition, will not be the end of consolidation in cable. For high yield eligible accounts, we picked up Forest Labs in the first quarter and it was promptly bought by Activas, an investment grade company, resulting in substantial spread compression that led us to exit our position. On the other hand, Mallinckrodt, an erstwhile triple-B credit, made a leveraged acquisition of Cadence Pharmaceuticals that prompted a (overdone, in our view) downgrade to single-B. This transaction illustrates the importance of buying a durable credit at a good price. Despite a very large downgrade, our bonds are trading close to our cost. We had hoped to buy more after the acquisition at an even better price, but markets did not offer a further discount. We believe this acquisition is strategically sound and a great fit to Mallinckrodt’s existing products. We expect the company to pay down debt rapidly, coming back to an investment grade rating over the next year or two.

While there have been large changes in sector exposures within our credit holdings, Corporate credit currently represents 30% of unconstrained client portfolios, ABS represent 25%-30%, CMBS represents 15%, and Municipal bonds represent 11%. While we have recently been selling more than buying, we still hold a portfolio of solid credits from these sectors that make up more than 80% of portfolio holdings. We are pleased that these holdings are enhancing performance. 

In Corporate and Structured credit, which make up the majority of unconstrained portfolios, the positions we have accumulated in REITS (1.18% excess return to Treasuries in Q1), Insurance (1.1%), Subordinate ABS (0.57%), CMBS(0.65%) and triple-B and split-rated Industrials (1.2%) did particularly well last quarter. Shifts in valuations caused us to rotate from Banks (0.32%) into these other areas over the last year, and we are gratified to see these positions generating substantial excess returns. We now hold only 2%-4% exposure to bank credits, which is one-third of what we held in early 2013.

Municipal obligations held in taxable portfolios are a mixture of longer yield opportunities, such as State of Illinois General Obligation bonds, bank sponsored Natural Gas bonds, and “broken” Auction-Rate Securities collected over the last few years. These were all positive contributors in early 2014, with longer Municipals beating equivalent Treasuries by 2.8% and the Auction Rates besting Treasuries by about 1%. This continues to be a market with distinct security-level opportunities, and it is a distinct and differentiated advantage that we operate as one team with our analysts and traders focused on identifying value wherever it resides, including Municipals.

Mortgage-backed securities lagged Treasuries for all but the highest coupons where our few holdings are concentrated. We have seen little value in the sector for a long time, and with the Fed gradually reducing its MBS purchases, we expect the lack of sponsorship to weigh on performance this year. 

As in prior quarters, there is a mismatch in duration appetite between investors and issuers. The most attractively priced credits we find tend to be long maturity, which poses a challenge to the management of portfolio duration. Our portfolio of individually selected credit values has a “barbelled” structure. In this environment, a barbell creates a sensitivity to long rates that is similar to a long duration position. We offset this by running the average duration of portfolios slightly short of target. 

Q1 was yet another quarter with substantial portfolio outperformance arising almost entirely from bottom-up security selection, particularly for our unconstrained accounts. We are pleased with our results and look forward to reviewing our strategies at upcoming meetings.

Andrew P. Hofer
Head of Taxable Portfolio Management


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