Taxable Bond Podcast 2Q13 (Transcript)

Michael Sullivan:  Hi, everybody. This is Mike Sullivan at GW&K. This is the Second Quarter 2013 Taxable Bond Update. I'm going to take 10 minutes today to talk about activity in the market during the second quarter. I'll talk about what happened to yields and to spreads. Then, I'll wrap it up with our positioning and our outlook going forward.

Well, it was a very challenging quarter for the taxable bond markets as improving economic data and expectations of Fed tapering resulted in significant yield and spread volatility.  There's really no place to hide out except for maybe cash as pretty much every taxable sector produced negative returns. For the quarter, 5 and 10 year treasury yields rose just over 60 basis points.  And 30 year yields rose 40 basis points. The Barclay's US Treasury Index lost 1.9%, and the long index was down almost 6%.

The worst performing part of the taxable market was TIPS, which is a sector that we have no exposure to. TIPS were down over 7% for the quarter. That weakness was driven not so much by their duration, but it was driven more so by a decline in inflation expectations, which is why you've also seen a selloff in commodities, gold in particular.

Another underperforming sector was Local Authorities, which includes taxable municipals. Local Authorities were down 5.2% for the quarter. While we did see some spread widening in that sector, the bulk of the weakness there was driven by duration, as it's one of the longest sectors in the taxable universe.

Looking at investment grade corporates, the High Grade Corporate index lost 3.4% during the quarter as spreads widened 13 basis points. That's the worst quarterly performance for the sector since the credit crisis.

From a sector standpoint, those spreads in the Financial sector widened more significantly than Industrial spreads. Financials overall outperformed, down 2.8% versus industrials down 3.5%. Now, this out performance is largely due to the shorter duration of the Financials index compared to the Industrials index.

Now, turning to high yields, believe it or not, High Yield was down only 1.4% for the quarter. Year to date, the High Yield index was still up 1.4%.  High Yield spreads widened 52 basis points for the quarter and higher quality BBs underperformed the lower quality CCCs.

Now, year to date, high yield spreads are still 19 basis points tighter than where they began the year, but if you break it down by credit quality, you'll see that all of that yield tightening has come in CCCs, which remarkably are still 100 basis points tighter for the year compared to BB and single B spreads, which are basically flat year to date.

Now, the reason that High Yield was only down 1.4% for the quarter was that fixed income markets, in general, had a relatively strong month of April. Now, during April Treasury yields declined 18 to 22 basis points out the curve and high yield spreads tightened 25 basis points.  For the month, the High Yield index was up 1.8%.

The real pain for the fixed income markets, and for High Yield in particular, really began in early May and lasted through to the last week of June. For example, from the first week of May to June 25th, the 10-year Treasury rose 99 basis points from 1.62 to 2.61%. Now, over that same time frame, High Yield spreads widened over 100 basis points from +402 to +510.  The yield-to-worst on the index, which had dipped below 5% for the first time ever, it dipped down to 4.95%. Over that same time period, it rose to 6.97%. Now that's a big move.
Really what drove that move was the Fed's successfully injecting uncertainty into the markets by initiating the tapering conversation and that specific to High Yield we experienced heavy outflows from high yield mutual funds and ETFs.  These outflows were felt most heavily in June, where we saw a record $4.6 billion outflow during the first week. And that was followed up by a $3.3 billion outflow during the second week and topped off with a $3.1 billion dollar outflow during the final week of the month. Now this retail selling pressure pushed spreads wider, pushed yields higher and reduced the weighted average dollar price of the index to $101.5 from a record high of over $107 in the early part of May.

Now shifting to our outlook, we continue to be constructive on High Yield Corporates. The yield-to-worst on the index ended the quarter at 6.66%, and while valuations are certainly not as compelling as they have been over the last couple of years, spreads are not nearly as tight as they have been in prior cycles.  So, for example if you go back to May of 2007, pre-financial crisis, you'll see that high yield spreads reached 246 basis points over Treasuries. And that was in a higher default environment than we are in today, and spreads today are twice as wide as they were then.

Now from a fundamental standpoint, fundamentals continue to be healthy. Credit quality continues to be sound, and defaults, as I mentioned, continue to be low. The default rate over the last 12 months is about 2.4% vs. the historical average closer to 5%.

Companies continue to be risk averse, and they continue to be focused on balance sheet strength. You can kind of see this conservative focus play out in the new issue market where refinancing remains the dominant use of proceeds. So year to date, 70% of the new deals in the high yield market have been for refinancing purposes vs. about 54% historically.

So we're not really seeing a huge levering up of balance sheets at this point in time in the high yield universe. So with that in mind, even with the recent volatility, we continue to believe that High Yield is the most attractive alternative in the taxable bond market given its shorter duration, its attractive carry and the opportunity for modest spread compression going forward.

In mid May, in our Total Return, in our Enhanced Core strategies, we tactically reduced our high yield position by about 3%.  And as the quarter ended we were prepared to redeploy that cash back into the market after the recent move higher in yields. Specifically, we're looking at best in class names in the high yield Finance, Materials and Mining sectors. And those have been the sectors that have been most out of favor during the recent weakness.

Now shifting to the other sectors, despite the recent increase in real yields, we continue to see little value in owning Treasuries and other government debt as meaningful real rates of return still require unreasonable amounts of interest rate risk. We continue to prefer Corporate Bonds over Treasuries, and we remain biased to BBB issuers, and we expect spreads there to compress as the recovery progresses.

We've also taken a tactical position in fixed to floating rate preferred securities, issued by tier one banks like Wells Fargo, and J.P. Morgan, and Bank of America. We like these securities because they trade at yields that are comparable to many high yield industrial credits. Yet, they have much more manageable credit risk.

We also like the defensive structure of these bonds as they pay a fixed coupon for the next five years. But, then they convert to basically durationless floating rate security, which will pay Libor plus 350 basis points, maybe a little bit more than that depending on the issuer.

We continue to maintain a 5% to 7% exposure to taxable munis in our strategies. We're also neutral in AAA government guaranteed mortgage-backed securities.  Now within that space specifically, we remain focused on the high coupon seasoned securities, which have provided a nice anchor to our portfolios. As they have relatively short durations and less extension risk when you compare them to some of the lower coupon mortgages that are less seasoned in nature.

Finally, from a duration and from a yield curve perspective, we've been gradually reducing the duration of our portfolios. We're currently committed to maintaining slightly short to neutral duration relative to our benchmarks. This defensive duration positioning is reflected in our yield curve exposure where all of our strategies are underweight the long end of the curve. Each strategy currently has 5% or less in a 20+ year bucket compared to the Barclay's Aggregate at 9%.

Instead, here, our preference is to be overweight the three to seven year part of the curve, which has less interest rate sensitivity and more potential to return from bond roll.

Just quickly, in summary, from a duration standpoint, we're slightly short to neutral compared to our benchmarks. We remain focused on the belly of the curve, the three to seven year maturity bucket, given the potential for roll there.  We continue to remain overweight spread product, overweight to hybrid corporates and high yield corporates for the income that they offer and the potential spread compression going forward. Then, also tactically, we look for products that are trading cheap relative to history or also that might perform well in a rising rate environment. That specifically is our preferred fixed to floating rate exposure currently in the strategies.

Finally, it goes without saying, we believe in the importance of staying diversified. As you know, one of the key benefits of our taxable strategies is you're gaining exposure to a number of different parts of the taxable market.  That really plays nicely in a volatile environment like the one we just went through where you saw our mortgages act as a really nice anchor for the portfolios overall. Again, we remained focused on staying diversified in these portfolios and recommend staying there going forward.

I'm going to wrap this call up. If you have any questions, at any point in time, please do not hesitate to reach out to us. Thanks a lot for tuning in.

This represents the views and opinions of GW&K Investment Management and does not constitute investment advice, nor should it be considered predictive of any future market performance. Data is from what we believe to be reliable sources, but it cannot be guaranteed. Opinions expressed are subject to change. Past performance is not indicative of future results.