October 15, 2020 | Cameron Parkhurst
Flight to quality, and Fedspeak, have caused Treasury yields to plunge toward all time lows
Many new issues are coming to market with very low coupons
Institutions (funds/ETFs) are one primary buyer of recent new issues and are being forced to methodically reinvest at lower and lower rates/coupons. Thus, portfolios are producing less income, while taking on more duration
Economic slowdown, primarily from repercussions of COV-19, continues to cause budgetary shortfalls for municipalities
We find duration here to be risky over the long term
We believe that there will be a wave of credit downgrades coming down the pike, especially in COV-19 impacted sectors. We have already seen a flurry of credit watches/downgrades, but expect a wave of further downgrades as financials are reviewed in early 2021 and throughout the summer months in Q2/3 2021 as filings are posted
Thus, we are positioning portfolios in higher quality muni and taxable muni sectors, and with limited duration, and trying to ballast portfolios for this impending wave
As viewed in the chart above, we have seen a long-term trend of Treasury rates moving lower. The economic uncertainties of 2020, based largely on the COV-19 pandemic, have caused rates to move sharply lower again this year, and we are essentially now sitting with yields at all-time lows. This, combined with the Fed banter regarding holding Fed Funds stable at these low levels, possibly through 2022/2023, is keeping front-end rates anchored. Additionally, with recent Federal Reserve balance sheet expansion (purchasing Treasuries, MBS and even corporate bonds & ETFs!), yields seem to be stable at these low levels for the time being.
Along with rates moving lower, most investment grade sub-asset classes have experienced spread compression. Investment grade corporate spreads have seen a good degree of compression in particular. Municipal sectors, outside of those that could be heavily impacted by covid-19 over the next few years (public transportation bonds, civic centers, regional airports, second tier universities, hospitals/nursing homes, smaller projects bonds, etc.), have also seen yields compress, leading to strong performance of the sector. While this is indeed the case, many of the “safer” names, such as State level GO bonds (which cannot file Chapter 9 bankruptcy), essential service revenue bonds, major universities/teaching institutions, etc., have remained at better yield levels than other investment grade sectors (especially when evaluating tax adjusted yields), and we continue to favor munis/taxable munis as a sub-asset class for your fixed income portfolios.
We are noticing that many new issues, however, are coming to market at low yields/coupons. While we are focused on using the bid side of the secondary market in order to purchase attractive odd lot paper for our RIA clientele, many institutions are forced to buy these low coupon, new issues (especially when seeing recent flows into bond funds/ETFs).This has allowed us to see declining dividend yields AND increasing durations for many core funds, and we expect this trend of lower dividends to continue if rates remain low.With this, we begin to ask ourselves if the risk/reward tradeoff is worthy of holding these funds vs. buying individual bonds using the bid wires. See below:
Ultimately, we believe that we can build a shorter duration, individual bond portfolio that has the potential to deliver more income/yield than by focusing on a core taxable or tax-exempt fund/ETF in this environment (along with the sleep at night factor of consistent, defined maturities).We don’t see the value in Treasuries and most industrial corporates here, and we see limited value in odd lot MBS for example. The main relative value play is in municipals/taxable municipals currently.
Importantly, when constructing portfolios, we have the latitude to maintain a direct focus on those sub-asset classes that we believe will hold up best if we get any derailment in the muni market in months to come. This involves quite a different level of due diligence, analysis and credit research than even we have done historically. The additional layers of analysis on muni balance sheets is extremely important in this environment. With our goal of safety of principal, avoiding a slow- moving train wreck (aka downgrades, volatility and even defaults) is of utmost importance. The muni market is not a fast- moving market, and it is fairly manageable to get out from under most slowly evolving stories as long as we continue to do our homework. As always, we will continue to monitor portfolios on behalf of our RIA clients and will be reporting back to you in a timely fashion, taking action where necessary for any unfolding credit events, both COV-19 related and otherwise.
Please do not hesitate to reach out to us with any questions about individual bond holdings or based around fund and ETF exposure. Many times, we can have collaborative conversations that can benefit your clients, or at the least be a point of education about what risks may be imbedded in your portfolios. We are always here to talk and answer any questions.
Thanks for the time!
Your PeachCap Fixed Income Team
A Few other charts that we see as pertinent and potentially impactful in today's market environment
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