Published on November 5, 2020
In October Treasuries resumed a steady rise in yields that began in August. Corporate and mortgage bond spreads narrowed, despite weakness in risk sentiment seen in equity markets. Although the election remains undecided, the bond market has rallied as investors are expecting a divided Congress – implying a smaller fiscal stimulus package and continued monetary support from the Fed.
- The Bloomberg Barclays U.S. Aggregate Bond Index (BC Agg) posted its third consecutive negative return in October, falling 45 basis points. U.S. MBS (+0.03%) delivered the best return, outpacing corporates (-0.14%) and Treasuries (-0.94%) for the month.
- Economic data continued to reflect improvement in the economy. The job picture improved as unemployment fell to 7.9%. PPI surprised slightly to the upside (+0.4% vs 0.2% expected) but headline CPI was in-line at +0.2%. Consumer sentiment indices also showed improvement, and housing starts and home sales continue to be strong. Finally, third quarter GDP posted a heady gain of 33.1%, reversing most of the loss seen during the second quarter.
- The Treasury curve resumed the bear steepening trend seen in August. The 5-year Treasury yield rose 11 basis points to 0.38%, the 10-year Treasury yield rose 18 basis points to 0.86%, and the 30-year Treasury yield also rose 18 basis points to 1.64%.
- Corporate spreads resumed their march down to pre-pandemic levels. The option-adjusted spread of the Bloomberg Barclays U.S. Corporate Index narrowed 11 basis points, ending the month at 125 basis points. The corporate sector outperformed duration-matched Treasuries by 99 basis points.
- The Bloomberg Barclays U.S. Mortgage Backed Securities Index outperformed duration-matched Treasuries by 12 basis points. Mortgage durations are extremely low, owing to the moneyness of most of the index given the fall in mortgage rates. On an absolute basis, MBS posted the highest return of the major investment grade sectors.
- The fund (-0.08%) outperformed the BC Agg (-0.45%) in October. Most of this outperformance is attributable to our overweight to MBS and corporates and underweight to Treasuries, as well as our slightly shorter duration profile than the benchmark.
Standardized performance can be viewed here: Monthly and Quarter End Performance
- In the first week of November, risk markets reacted favorably to what appears to be a gridlocked Congress (Republican Senate, Democratic House). The bond market also reacted favorably since the likelihood of a blue wave (Democratic sweep of Presidency, Senate, and House) has dissipated.
- A blue wave would have likely paved the way for the largest possible fiscal stimulus package, which itself would likely stoke inflation and increase Treasury issuance. In addition, it would also feature the highest likelihood of significant tax increases, which would hurt risk assets (in particular, equities and corporate bonds).
- A gridlocked Congress, regardless of the winner of the presidential race, would yield the smallest stimulus package, and leave the current tax code intact. The first two days of trading after the election have seen interest rates fall and risk assets (equities, corporate bonds, and MBS) all perform well as this appears to be the consensus outcome.
- The greatest uncertainty in the forecast is whether the Republicans will retain the senate, as Georgia seems to be headed to at least one runoff election in January. At this point, it seems we will not have a clear picture until then, although Republicans are favored to win a runoff in Georgia at this time.
- If the consensus election forecast holds and Republicans retain the senate – a view we share – we continue to favor an overweight to corporate bonds and current coupon MBS. In this scenario we see a delayed rise in Treasury rates and believe the Fed may be compelled to increase its quantitative easing program if it feels the potential fiscal stimulus package that could be offered is insufficient to stoke an economic recovery.
- If the possibility of a blue wave were to rise, we would be much less constructive on corporate credit and interest rates. Further, current coupon MBS could suffer if a rate selloff were to trigger originator selling and convexity hedging.
- Against this election uncertainty, any change in the trajectory of the pandemic will also have a secondary effect on fixed income markets. Increases in cases, hospitalizations, and deaths (a second wave) will likely hurt risk assets (wider spreads) and trigger a Treasury rally. Any development of a vaccine or improvement in health outcomes related to the virus will be positive for risk (tighter spreads) but could see interest rates rise on the prospect of a more robust economy (and thus less Fed stimulus).
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The Bloomberg Barclays U.S. Aggregate Bond Index (BC Agg) is an unmanaged index which is widely regarded as the standard for measuring U.S. investment grade bond market performance. This index does not incur expenses and is not available for investment. The index includes reinvestment of dividends and/or interest income.
The Bloomberg Barclays U.S. Mortgage Backed Securities (MBS) Index tracks agency mortgage backed pass-through securities (both fixed-rate and hybrid ARM) guaranteed by Ginnie Mae (GNMA), Fannie Mae (FNMA), and Freddie Mac (FHLMC). The index is constructed by grouping individual TBA-deliverable MBS pools into aggregates or generics based on program, coupon and vintage.
The Bloomberg Barclays U.S. Corporate Index includes publicly issued U.S. corporate and specified foreign debentures and secured notes that meet the specified maturity, liquidity, and quality requirements. To qualify, bonds must be SEC-registered. The index includes exclusively corporate sectors, including Industrial, Utility, and Finance, which include both U.S. and non-U.S. corporations.
Sector returns above are those of the Bloomberg Barclays U.S. Aggregate Bond Index.
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A basis point is a unit that is equal to 1/100th of 1%.
Coupon is the interest rate stated on a bond when it’s issued. The coupon is typically paid semiannually.
Investment grade bonds are bonds with high and medium credit quality assigned by a rating agency. For Standard and Poor’s, investment grade bonds include BBB ratings or higher. For Moody’s, the cutoff is Baa.
A mortgage-backed security (MBS) is a type of asset-backed security that is secured by a mortgage or collection of mortgages.
A mortgage TBA serves as a contract to purchase or sell an MBS on a specific date, but it does not include information regarding the pool number, number of pools, or the exact amount that will be included in the transaction.
Duration measures the sensitivity of a fixed income security’s price (or the aggregate market value of a portfolio of fixed income securities) to changes in interest rates. Fixed income securities with longer durations generally have more volatile prices than those of comparable quality with shorter durations.
Spread is the difference in yield between a risk-free asset such as a U.S. Treasury bond and another security with the same maturity but of lesser quality.
Option-Adjusted Spread is a spread calculation for securities with embedded options and takes into account that expected cash flows will fluctuate as interest rates change.
Consumer Price Index (CPI) is a measure that examines the weighted average of prices of a basket of consumer goods and services, such as transportation, food and medical care.
The producer price index (PPI) is a group of indices that calculates and represents the average movement in selling prices from domestic production over time.
It is not possible to invest in an index.
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