Q1 2021 – Farewell to the Great U.S. Bond Rally?
For 40 years, gradually declining rates have provided bond investors a helpful tailwind of price return above their purchase yield. From a 1981 peak of 16% during the Volcker era, the 10-year yield has meandered downward to a low of 0.5% in August of last year. As a result of this mega-rally, an investor in the Bloomberg Barclays U.S. Treasury Index over that period earned a tremendous 51% price return in excess of their coupon – working out to about 1% annually. This has benefited holders of longer duration notes in particular, softening the impact of short-term rate swings.
The first quarter’s sharp rate rise may, however, constitute a definitive end to that long, benign run and usher in an unpalatable turn – sustained periods of negative price returns as yields rise from their low levels. Holders of long-duration portfolios may now turn in to and contend with persistent headwinds muting returns. The rise in intermediate and long rates through March, which steepened the yield curve, is driven by several factors – a lift in anticipated economic growth, the passage of massive fiscal stimulus, continued expansive monetary policy, and rising inflation concerns – all of which we will discuss below. The consequent capital loss for bond investors with meaningful rate exposure has been severe. The Bloomberg Barclays Aggregate bond index, with 6.4 years’ rate duration, lost more than 3% of its value through the end of March.
Low yield levels across the curve, alongside purchase competition from the Federal Reserve (Fed) for Treasuries and agency mortgage-backed securities (MBS), have driven investors to the credit markets for greater yield. Investment grade (IG) bond funds have accordingly seen strong flows. But incremental compensation on offer in corporate credit is mostly tapped out. Both IG and high-yield (HY) corporate spreads over Treasuries stand at their tightest levels since 2006. Credit fundamentals are improving, but are far from pristine, and maturities are long – averaging nine years duration in the Corporate index.
Unsurprisingly, it’s the overlooked and less familiar segments of the credit market that offer both attractive value and lower rate exposure today. For example, in contrast to the large price declines suffered this year across fixed income, BBH’s Structured Strategy (the “Strategy”) – focused primarily on short tenor non-traditional1 asset-backed securities – returned 1.8%2 last quarter. One-year composite returns are 11.9%, and annual returns from inception in early 2016 are 4.9%, with solid positive returns in each succeeding year. A representative account in the Strategy today offers a 4.3% yield on a high-quality, two-year duration, IG portfolio that is well diversified across more than 20 subsectors. That’s a compelling option in the current yield-challenged environment.
In this Quarterly Update, we delve further into the source of the sharp rate sell-off and curve steepening in the first quarter. We note the potential for further rate increases and offer our guidance to investors to favor higher carry, shorter duration positions. Following this, we lay out a brief summary of the technicals, compensation, and credit outlook across the major fixed income sectors. We acknowledge the paltry spread compensation investors face today across most sectors, while parts of the structured credit market still screen favorably. Next, with the benefit now of a full year’s perspective, we review the durability of the asset-backed securities (ABS) sector through the pandemic – its low return volatility versus other credit sectors at the height of last March’s dislocation and its spotless credit performance across 30-plus subsectors (excepting aviation). As independent support for ABS’ credit stability, we undertake a thorough analysis of every ABS downgrade by the agencies over the last 15 months. Finally, we discuss last quarter’s issuance and spread activity across structured credit markets and provide a description of the many opportunities in which BBH participated – purchasing $900 million in structured credit across our mandates in the first quarter.
No taper, just tantrum
We noted in our January Quarterly Update that with fixed income market yields at all-time lows, bond investors this year would suffer negative returns with even a tiny sell-off in rates or spreads. Well, the rate move came fast and large in the first quarter. U.S. intermediate and long rates shot up at their fastest pace since the Taper Tantrum of 2013, with U.S. 5-year and 10-year Treasury yields rising 58 basis points3 (bps) and 85 bps, respectively. If you include the gradual pickup in rates since August 2020, U.S. Treasury yields have spiked more than through all of 2013 – and without the Fed even signaling a tapering of its Quantitative Easing (QE) program. Short U.S. rates, up to two years, continue to be anchored near zero by the Fed’s determination to keep the Fed Funds rate at zero. The upshot has been a sharp yield curve steepening (as shown in the green line in Exhibit I) that has spared shorter bonds from poor returns, but savaged longer-duration positions.