Schuyler Reece: Hi, this is Schuyler Reece at GW&K and I will be reviewing the second quarter of 2014 for the Taxable Bond team. I'll take a few minutes today to provide a brief synopsis of the market moving events of the past three months, briefly review the performance of our strategies, and discuss our positioning and outlook as we move into the second half of the year.
Coming into the second quarter, investors worried that higher interest rates were on the horizon. After all, one of the worst winters in recent memory had just come to a close, and the economy seemed poised for a sharp rebound.
Additionally, a hawkish interpretation of the late March FOMC meeting caused a violent repricing of front-end interest rates and reminded market participants that the extraordinarily accommodative monetary policy of the past few years was nearing its end.
Given these expectations, a further rally in yields and the resulting flattening of the yield curve caught the market off guard. While a number of factors contributed to the move lower in yields, we think that there were likely three major drivers: simmering conflicts in Ukraine and Iraq, the specter of deflation in Europe, and a reassessment of the Fed's view for the appropriate long run fed funds rate.
While the market has largely tried to categorize the burgeoning civil wars in both Ukraine and Iraq as isolated events, we believe that these conflicts have caused a modest flight to quality and point to parts of the commodity complex rallying alongside interest rates as evidence of this. Although the global economy is less exposed to an energy shock now than during previous crises, any further escalation in either theater certainly has the potential to weigh on overall sentiment. With respect to Europe's lackluster growth, a worrisome trend in prices forced the hands of the European Central Bank (ECB), which delivered an aggressive package of monetary stimulus in June. After telegraphing such a move for several months, the ECB cut all three of its benchmark interest rates. In a historic move, it actually cut its deposit facility rate below zero, the first time a major central bank has moved its deposit rate into negative territory.
Additionally, it announced plans for another long-term refinancing operation akin to those that used to stave off the worst of the sovereign crisis in 2011 and 2012, as well as indicating that it was exploring the feasibility of outright asset purchases. Certainly the scope of this announcement indicates the severity of the threat that the ECB sees from deflation, as this remains a malaise for which central banks have no cure.
As with other easing announcements, markets broadly rallied. Interestingly, however, the rally in peripheral European rates left many wondering whether yields on 10 year Treasuries were actually too high given the low yields seen across most of Western Europe, especially in some still stressed economies.
Domestically, while the market was caught off guard by the upward movement in the Fed's median expectation for the funds rate at the end of 2015 and 2016, it was the move downward in their projection for the long run rate which has garnered more attention.
The implications of such a move, and most importantly what it means for potential output and inflation, drove a further flattening of the yield curve. Despite manufacturing, employment and inflation indicators firming during the quarter, wage growth has remained elusive, and is giving the Fed the ability to guide the market to expect a drawn out and shallow path for normalization of the fed funds rate.
Despite this firmer economic data modestly weighing on front-end rates, the yield curve flattened toward a five year low during the quarter as the 2 year yield rose 4 basis points while the 5, 10 and 30 year Treasuries rallied 9, 19 and 20 basis points, respectively. The rally in yields drove the 1.4% return in the Treasury index during the quarter which is now up 2.7% thus far this year.
The long bond returned 5.2% and to the chagrin of the many bond bears, with this year's 61 basis point rally in yields is up nearly 14%.
Despite the simmering conflicts in Eastern Europe and the Middle East, the combination of new stimulus from the ECB and broadly supportive technicals helped drive spreads tighter alongside the rally in interest rates.
As such, the Barclays Aggregate Index returned 2% and is up nearly 4% this year. Within the Aggregate, investment grade corporates remain the top performing sector as a benign default outlook continued demand for yield and favorable conditions for corporate fundamentals helped drive spreads through the 100 basis point threshold, where they closed at 99 basis points over, some 7 basis points lower during the quarter.
This propelled investment grade to a return of 2.7%, implying excess returns of 75 basis points. With spreads now 15 basis points tighter this year and longer-term yields a half a point lower or more, investment grades returned 5.7%, implying excess returns of 150 basis points through the first six months of 2014.
At the quality level, BBB rated corporates continued to provide leadership, tightening 11 basis points during the quarter and returning 3.2%. Spreads in higher quality corporates lagged as A rated bonds tightened only 3 basis points while AA rated bonds were unchanged during the quarter, and these qualities returned 2.4% and 1.9% respectively.
At the sector level, Utilities rebounded from a lackluster first quarter and tightened 20 basis points, returning 3.4%, while Industrials and Financials tightened 7 and 3 basis points, respectively, and returned 2.8% and 2.2%.
Following its tenth consecutive month of positive returns in June, high yield closed the quarter up 2.4%, implying excess returns of 143 basis points. Year to date returns stand at 5.5%, implying impressive excess returns of 342 basis points.
During the quarter's rally, the option adjusted spread of the Barclays U.S. High Yield Index tightened 21 basis points and closed the quarter at 337 basis points, nearly 50 basis points lower than where it started the year.
At the quality level, BB rated corporates modestly outperformed as their longer duration benefited more from the rally in rates. On the quarter, BBs returned 2.7% relative to performance in Bs and CCCs of 2.2% and 2.4%, respectively.
With spreads lightening tighter by 6 basis points, the Government Related sector returned 2.2% during the second quarter, implying 86 basis points of excess return. Spreads in the sector are now 10 basis points lower year to date and the sectors returned 4.4%, implying excess returns of a 150 basis points.
Within the space, taxable municipals are a notable outperformer, and aggregate eligible taxable munis tightened 13 basis points during the quarter and returned 5.4%, implying some 231 basis points of excess return. While this strength was fairly broadly based, California was upgraded one notch by Moody's to Aa3 and its large weight in the index certainly helped drive performance.
The securitized sector also rallied during the quarter as the combination of sharply lower supply, FHFA director Mel Watt's decision not to extend the window for HARP refinancing, low rate volatility, and the prospect for a longer runway for principal reinvestments by the Fed drove agency mortgage spreads 14 basis points tighter.
Given this tightening, agency mortgages returned 2.4% during the quarter, implying some 92 basis points of excess return. Mortgages have now returned 4 % year to date, and with spreads tighter than the beginning of the year, excess returns stand at 68 basis points.
I'm happy to report that all of our strategies outperformed their benchmarks during the second quarter, with the exception of the Short Term Taxable Bond Strategy, which lagged by 2 basis points.
Drivers of performance remained fairly consistent across the majority of our strategies, as we were mildly hurt by duration in the curve during the quarter, given our shorter duration and underweight to the long end. Fortunately, our decision to remain overweight spread products including high yield were allowed at the expense of the Treasury sector continues to support performance. Additionally, selection remains a key driver of performance.
Continuing a trend we saw in the first quarter and throughout 2013, selection within our investment grade positioning, particularly BBBs, remains excellent.
Adding to this strength during the second quarter with strong performance in some of our BB names, which helped portfolios which own high yield. Our taxable municipals continued to tighten during the quarter and remain a key driver of overall performance as well.
On the negative side, performance in our agency NBS positioning lagged modestly, as we continue to position ourselves defensively within the space and our premium coupon pools lagged the broader rally in the securitized market.
Thus far this year, each of our strategies has outperformed its benchmark, and attribution analysis reveals very similar contributors to overall performance.
Moving into the second half of 2014, market volatility is likely to stay low as the Fed maintains its zero interest rate policy, which it's expected to do through September of 2015. As we approach the inevitable tightening cycle, rates at the front end of the curve are likely to rise while the longer end should remain relatively anchored by low inflation expectations and a modest long-term growth outlook.
Ultimately, we think that slow but positive growth, gently rising interest rates, and strong consumer and corporate balance sheets support a favorable view of risk assets, though there are a number of factors that could make this path a bumpy one.
Given our expectation of a modest cyclical rise in interest rates as economic data continues to improve and QE comes to an end, we remain slightly underweight duration. We maintain our focus on the intermediate exposure because we believe valuations remain attractive and we expect the extra carry to provide returns that are more than adequate to offset the risk of higher interest rates in that part of the curve.
We continue to prefer investment grade corporates over Treasuries, given their defensive spread cushion, and our expectation of continued strength and profitability and responsible financial policies among investment grade issuers. Spreads of 99 basis points over Treasuries offer room for modest compress as credit metrics to improve and institutional demand for quality spread product remains firm.
Within the investment grade space, we have a strong preference for BBB credits, which offer an attractive spread pickup versus A rated credits for acceptable levels of incremental credit risk. We continue to have overweight positions in the more cyclical corners of the market, which we expect to be the biggest beneficiaries of an economic recovery and where weak sentiment has made valuations attractive.
We're similarly inclined to buy high yield and eligible portfolios as a benign default outlook, strong fundamentals and robust demand for yield support a favorable view of the space. We see room for spread compression in high yield relative to historical levels as well, and believe that an allocation to this sector also offers protection in the event of rising interest rates.
We do recognize that there are downside risks in credit given valuation inside of historical averages and less liquid markets following regulatory changes, but we continue to believe the space offers value. Here too we also find the most attractive valuations in the more cyclical sectors.
Lastly, we remain neutral on mortgage backed securities. Though we still believe yields are attractive relative to Treasuries, negative technical pressure following the removal of Fed support could lead to potentially wider spreads. Within mortgages, we continue to favor short duration, higher coupon assets that offer better carry and less spread duration.
I'll conclude my comments there. Thank you so much for listening. I hope you enjoyed this quarter's podcast. As always, if you have any questions about our views or positioning, please don't hesitate to give us a call. Thanks.
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.