Total Return Perspectives: June 2020

Market Review:

• Risk assets continued to perform well after the bottom in late March, as fiscal and monetary stimulus programs continue to support markets and we have emerged from the depth of the economic trough. The Federal Reserve has committed to purchase Treasuries and Agency MBS through the end of 2021.
• Economic data reveals continued improvement off lows in late March/early April.
• Month over month, the Treasury curve is little changed, with all yields remaining within 2 basis points of their levels at the end of May. In June the 10-year Treasury yield rose 1 basis point, from 0.64% to 0.65%, while the 5-year Treasury yield fell 1 basis point from 0.30% to 0.29%. This relative calm belies intramonth volatility, as the 10-year yield rose to 0.90% on June 5. The commitment to purchase Treasuries and MBS at the Federal Open Market Committee meeting on June 10 helped Treasuries rally back to their prior levels over the next week. Treasuries returned +0.09% in June, bringing the year-to-date return to 8.71%.
• Corporate spreads continued to fall toward their pre-pandemic levels. The corporate sector outperformed duration-matched Treasuries by 189 basis points, as the option-adjusted spread of corporates narrowed 24 basis points to close June at 150 basis points. This level is just 28 basis points wider than it stood at the end of February.
• Mortgages trailed duration-matched Treasuries by 13 basis points, largely due to underperformance of higher coupon MBS on fears of rising prepayment risk. Lower coupon MBS, which are but a small part of the index, significantly outperformed higher coupons.
• The fund (+1.14%) outperformed the Bloomberg Barclays U.S. Aggregate Bond Index (+0.63%) in June. The fund benefited from its moderate overweight to longer dated corporate bonds, its position in lower coupon MBS, and its position in inverse interest only (IO) bonds – all of which delivered better performance than Treasuries which remain an underweight position versus the index.

Standardized performance can be viewed here: Monthly and Quarter End Performance

Outlook:

• The economic downturn has moderated somewhat, as we have seen modest reopening of economies globally. While we seem to have averted the worst health outcomes that were projected in March, we have seen some interruption in the reopening of the economy as cases have started to rise in areas that reopened earlier.
• Nevertheless, many risk markets (notably equities) have continued to decouple from the underlying news headlines which now include these new measures to stall the reopening of businesses. We continue to attribute this disconnect to monetary stimulus measures. Delinquency data for non-mortgage receivables (credit cards, auto) continue to track better than our expectation, though we will monitor these areas to understand the health of the consumer, especially in light of renewed regional shutdowns and uncertainty around whether fiscal stimulus measures will continue past July.
• Corporate spreads narrowed in sympathy with equity outperformance. As official purchases of corporate ETFs and individual corporate bonds have begun, we believe spreads can continue narrowing despite weakness in underlying economic data. However, current valuations give us some pause when evaluating fundamentals and we would look to reduce our position if spreads were to tighten materially.
• Our highest conviction remains an overweight to mortgages – specifically lower coupon mortgage pools and mortgage derivatives off very seasoned collateral that is less sensitive to rate-induced prepayments.

Eddy Vataru

Chief Investment Officer – Total Return