Taxable Bond Podcast 2Q15 (Transcript)

Chris Iovanna: Hello, this is Chris Iovanna, client portfolio manager here at GW&K. This is the Q2 2015 taxable bond podcast.

We're going to touch on markets first, and then get into our strategies and our outlook. For the second quarter, we saw some pretty significant pressure in fixed income markets. We don't think it's the signal of a longer downturn. There was just a lot of volatility with interest rates. There was basically a falling of the European markets, which had experienced a lot of volatility there, too. We'll get to that in a minute. What you saw was a bear steepening of the Treasury curve. The 2-year was up about eight/nine basis points on the quarter. The 10-year was up 43 basis points. The 30-year was up about 58/59 basis points. That reversed what we had seen in the past. We had been undergoing a bull flattening, where we were seeing rates at the long end of the curve come down much further than rates at the short-end of the curve. In Q2, that was reversed, and basically, there were a few different reasons for that. I can get into those now.

One was, again, the big spike in European debt yields. If we just use the 10-year German Bund as a proxy, we saw on April 20th it hit its closing low at 7.5 basis points. That was basically after investors plowed into European debt due to the European Central Bank's announced bond buys. Obviously, that trade was pretty crowded there and ran too far, too fast. By the end of the quarter, the 10-year Bund rocketed back up and finished the quarter at 76 basis points.

We also saw better economic data coming in overseas, somewhat improving data domestically as well. The employment reports have generally trended better, even though there's been some bumps in the road and some specific issues within the employment reports. But overall, those have been a bit healthier. Core CPI has been firming a bit. The consumer's still pretty slow to heal, but they're showing signs of some life there. A little better economic data overseas and domestically. The market is always forward looking, so the thought is that the second half growth is going to be better than the first half growth.

In Q1, we saw GDP at 0.2%. Q2 looks to be coming in probably in the mid-2% range. Those aren't really great rates for first half growth, but some of the estimates coming in for second half growth, I think the market is looking for 3% GDP or so. That would help, again, with that bear steepening, helping to push up intermediate to longer-term rates, which are much more sensitive to inflation and growth expectations.

There's also been a lot of dovish news coming out of the Fed. The thought may be out there that the Fed could be behind the eight ball as far as raising rates are concerned. Because again, the intermediate to long end of the curve is very concerned with inflation growth, inflation expectations. If the Fed is very dovish and gets behind the eight ball, as far as not raising rates in time to head off inflation, it's no surprise that the market is pricing that in and rates are ticking higher because of that.

That's the rate side of the market. If we look at performance, the Barclay's Aggregate was down -1.68%. The Treasury sector returned 1.58%, a little bit better in Treasuries. Taxable municipals had a really tough quarter. That's a longer duration sector. That was down -4.01%. On the other hand, mortgages were down 0.74%. They were helped by their relatively short duration compared to the Index.

Investment grade corporates got hit pretty hard, down -3.16%. That was due to a combination of a selloff in Treasuries and 16 basis points of spread widening. The spread widening there pushed premiums to the highest levels, pushed Treasuries to the highest levels in two years. It was pretty broad based. AA and A-rated bonds widened 13 basis points. BBBs were worse, widening 17 basis points. High yield returns were flat, so 0% returns. They benefited from their higher coupon, their higher income, and they experienced 10 basis points of spread widening. Again, that higher coupon helped to alleviate that and they ended up flat.

If we move on to our Strategies, we underperformed during the quarter for our taxable Strategies. We were overweight in investment grade corporates at the expense of Treasuries. Investment grade corporates underperformed, again, due to their longer duration. Conversely, Treasury returns beat the Index. Another negative was our allocation to taxable municipals. The drag from this sector was again due to their longer duration. For our Strategies that had high yield exposure, our allocation to the sector aided returns, but security selection proved to be a drag. That really was the main driver for underperformance for the quarter for those strategies that could hold high yield. Allocation to mortgages helped. They outperformed the Index. Our favor for higher coupon paper in that sector was beneficial. That paper held up well in a rising rate environment.

Overall, duration was mostly neutral across our strategies and yield curve positioning was moderately positive. At this point, our Strategies are essentially neutral weight with respect to duration and curve positioning. There's what we see as a bias to an upside in rates. With improving economic data, there's upward pressure from the Fed to act. The market is pricing in a greater chance of them acting in December than September, but three months difference may not make a big deal. What will make a big deal is the pace of the increase in rates, but we think the pace won't be too extensive. From the rhetoric coming from the Fed, it looks like they would like to start raising rates if the data calls for it, but when they do they will likely raise rates, let the market digest it. They'll observe the data from there and they will continue to do so at a slow and measured pace if the market is digesting that well and if the data continues to come in a positive manner.

There's also tail risks out there. The Greece situation seems to be alleviated right now, but will probably continue to play a role in market sentiment. There's obviously a concern with the slowdown in China, and continued turmoil in the Middle East. We see the most compelling value in intermediate maturities in both the Treasury and credit curves. There's some attractive carry and role available for rates assumed on those parts of the curves.

Corporate bonds--we're going to continue to overweight those. We find them attractive relative to Treasuries. Current spreads are attractive. We're going to overweight that sector. We expect corporations to continue to benefit from positive revenue growth, robust profit margins. They've exhibited discipline when it comes to their balance sheets. That's another positive. Corporates also have a buffer against a risk of rising rates. There's a potential there for spread compression to absorb any move in rates. Within the investment grade sector, the incremental spread available in BBBs relative to As we think is more than adequate for the additional risk being assumed. We will overweight that credit tranche. We remain overweight in Industrials. We think valuations are attractive there and that part of the corporate market will likely benefit the most from an ongoing U.S. recovery.

As far as high yield is concerned, we remain constructive on the high yield space. We're going to generally remain overweight high yield in all eligible Strategies. Spreads are about 140 basis points higher than where they were a year ago. High yield offers attractive carry and also the potential for spread compression. Within the high yield space, we're going to have a preference for higher quality energy companies. That's going to be our largest overweight. We also see some value in basic materials, as well.

Our allocation of mortgages is basically neutral. We have a neutral outlook on spreads in that space, but they have a lower sensitivity to rising interest rates due to their lower duration. They also offer a defensive alternative to credit. We'll overweight season pools and high coupons within that space. That's it. That concludes our podcast. Thank you for listening. We look forward to speaking with you next quarter.

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.