Taxable Bond Podcast 4Q13 (Transcript)

Michael Sullivan: Hi, this is Mike Sullivan at GW&K. This is the fourth quarter 2014 update for our taxable bonds strategies. I'll take about 10 minutes today to provide a brief overview of what happened in the markets during the fourth quarter and for the year. I'll touch a little bit on performance for our strategies throughout the year, and then I'll wrap it up with our outlook for 2014.

Looking at the quarter, Treasury yields jumped about 30 to 40 basis points from the 5-year point out. At the shorter end, we didn't see as much of a move higher in yields. The 2-year Treasury yield only moved about six basis points higher for the quarter.

The reason for the move higher in interest rates is stronger economic data. We had strong employment numbers during the quarter, improving manufacturing data, as well as improving consumer confidence. All of these factors, combined with the Fed taper in December, led to the move higher in interest rates.

As it pertains to the Fed taper, I think we're all pretty aware that they announced a $10 billion reduction in bond purchases on a monthly basis. It's important to recognize that the Fed is now in the process of transitioning away from QE and moving towards forward rate guidance as its primary policy tool.

As part of the announcement to reduce purchases, Ben Bernanke said that the target rate for fed funds is going to remain on hold well past the time that unemployment drops below 6.5%. That's a critical piece to this transition process.

For the year, the Treasury market was volatile, and most of that was due to the improving economic data as well as the Fed tapering conversation, with yields beyond 5 years basically rising 100 basis points. The 5-year Treasury moved 102 basis points during the year. The 10-year moved 127 basis points higher. The 30-year moved just over 100 basis points higher as well. The U.S. Treasury Index was down 2.8%.

High-grade corporates had a solid quarter and were up 1.1%. The positive return was nice to see in light of the higher Treasury yields. Spreads tightened about 27 basis points for the quarter, and much of that tightening occurred in December, as the high-grade market embraced the Fed's "Tapering is not tightening" mantra.

On a year-to-date basis, the investment-grade corporate index was down 1.5%. Those spreads did tighten 27 basis points on the year.

Down in quality outperformed with BBBs declining 0.9 % for the year, AAs were down 2.5%, and AAAs were down a little over 4.5%. Financials consistently outperformed Industrials throughout the year. Financials were actually up just under 1%. Financial spreads tightened 46 basis points for the year, compared to Industrials, which were down about 2.5% for the year. Financials outperformed because they have a shorter duration, and there's not as much event risk in that sector right now. Whereas Industrials are subject to M&A risk and they're subject to shareholder-friendly actions.

High yield had a very strong quarter and a very strong year, both on an absolute and a relative basis. For the quarter, high yield spreads tightened 79 basis points, and the Barclay's High Yield Index was up just over 3.5%.

For the year, despite the 100-basis-point rise in Treasuries, high yield bonds still produced a 7.5% return for the year. Spreads tightened throughout the year with the exception of May and June where there was increased volatility. Overall, spreads tightened 129 basis points and ended the year at 382 basis points over Treasuries.

Like investment grade, down in quality outperformed. CCCs tightened 221 basis points and were up almost 14% for the year. Whereas BBs tightened only 90 basis points and were up just over 5%.

The strong tone in the high yield market indicates to us that high yield investors are comfortable with the move higher in Treasury yields. Along with that move higher comes improving macro-fundamentals. We think that should continue to be the case in 2014.

Finally, in the mortgage sector the mortgage index was down 0.4% for the quarter. They outperformed Treasuries, as spreads tightened about nine basis points in the sector.

Year to date, mortgages outperformed Treasuries, particularly higher coupon mortgages, which held up well through all the volatility during the year. On a year-to-date basis the mortgage index was down 1.4%, compared to Treasuries, down 2.75%.

Turning over to take a look at our strategies from a performance perspective, all of our strategies outperformed their respective benchmarks on a quarter-to-date and year-to-date basis. In addition, all of our strategies produced positive returns during the fourth quarter. For the year, with the exception of our Core Bond Strategy, all of our strategies produced positive returns for the year.

The reasons for the outperformance were pretty consistent across all of the strategies. First and foremost was our lack of exposure to Treasuries. We have very little exposure to Treasuries in our strategies. For strategies that can hold high yield, we were overweight relative to our benchmarks. Given the strong returns in that space, that overweight certainly helped.

Our decision to be overweight investment grade corporates also helped. What we're particularly proud of for the year was our credit selection in the investment-grade space. We had solid credit selection throughout the year, and again that contributed nicely to our outperformance.

Finally, in mortgages our focus on higher coupon season pools resulted in some outperformance relative to the mortgages in the index. We had a strong year on a relative basis for performance.

Turning to our outlook, generally speaking, what we expect for 2014 is slightly higher rates and modestly tighter spreads. We think that the growth momentum that we saw in the third and the fourth quarter of last year should carry through into 2014 as the tight fiscal policy that we've experienced over the past couple of years continues to fade. Policy uncertainty is also on the decline.

The key to this outcome is clearly the Fed and whether it's able to successfully transition away from QE and transition towards its forward rate guidance as the primary policy tool. This transition is going to have to be handled carefully and it's going to require flexibility and a significant amount of ongoing communication.

From a strategy standpoint, we continue to be mildly bearish on duration. We continue to be overweight 3-7 year maturities, and we continue to be underweight the long end of the curve. As a result, we're about a half-year shorter duration-wise in all of our strategies relative to their benchmarks.

We think the carry trade environment is going to persist here in 2014, and we think investment grade corporate spreads will tighten modestly. We continue to focus on BBB corporates for the extra yield that they provide and we're going to continue to look for opportunities in some of the wider trading sectors as a way to pick up some nice yield and also get some potential return from spread tightening there.

We continue to be overweight in high yield and focused on the higher-quality part of that market, the BB and B rated bonds. We particularly like B rated bonds in this environment as they provide nice, short-duration exposure, solid income and also low default risk in 2014.

Beyond that, with high yield spreads up in the 380s, we think that there is still some room for spread compression, as defaults are expected to remain low over the next 12 months.

In mortgages we remain neutral and focused on our higher coupon season pools. Those pools really provide us with some nice protection against extension risk and they also provide us with some nice short-duration holdings. There could be some spread widening in the mortgage market during 2014 as the Fed backs away, so we might look for an opportunity to go underweight mortgages at some point during the first quarter.

I'm going to wrap the podcast up right there. Thank you very much for listening. If you have any questions about our views on the market, what our outlook is for 2014, or if you have any questions about our strategy specifically, please do not hesitate to give us a call.

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.