Risk markets performed well across the board in the first quarter of 2017 as the Trump rally trade continued virtually unabated. The global risk-on rally showed few cracks developing, with trends pushing higher even though there were a number of obstacles to overcome. The markets faced uncertainty on numerous fronts in the first quarter, including the change of power in the White House with President Trump taking office in January, a flurry of executive orders, Congress’ failure to repeal and replace Obamacare, the Federal Reserve’s third interest rate hike of the cycle, and growing geopolitical tensions with North Korea firing missiles, just to name a few.

Even so, the markets remained very calm with volatility seeming to hibernate. For example, the S&P 500 enjoyed a 109-day streak without a 1% decline, its longest stretch in nearly 22 years. The benchmark went 55 trading days without a 1% daily move in either direction, the longest such streak since 2014. In fixed income, credit dominated with the Barclays High Yield Index gaining 2.70%, the Barclays Intermediate Term Credit Index gaining 1.14%, and the Barclays 7-10 Year Treasury Index positive by 0.94%.

The Federal Reserve did hike rates for only the third time in the cycle and suggested more hikes. Possibly two to three more are in the offing this year. The market doesn’t seem to believe the Fed will hike that much, evidenced by the fact that the 10-year Treasury Note yield has peaked concurrently with each of the three Fed rate hikes. If the market put any trust in the Fed’s willingness or ability to hike more rapidly, we believe the 10-Year Treasury Note yield would remain firmer after each rate hike.

First Quarter Attribution

The Fixed Income Total Return (FITR) portfolio remained fully invested in high yield bonds during the first quarter, as has been the case since the allocation to the high yield bond sector over one year ago on February 29, 2016. For the quarter, the Fixed Income Total Return portfolio rose 2.57% gross of fees (1.81% net), marginally trailing the Barclays High Yield Bond benchmark which gained 2.70% and outperforming the Barclays Aggregate Bond benchmark, which gained 0.82%. The portfolio’s performance was again driven by its allocation to credit risk, which performed well in the quarter given a supportive economic environment and continued spread compression.

Credit spreads have steadily contracted since peaking at 840 bps on February 2016. Spreads ended the quarter at 345 bps, which is below the mean spread of 544 bps since 2000, arguing that high yield bonds are expensive. While valuations are a concern and may be a headwind to future high yield bond returns, we would caution against turning negative on the sector purely based on valuations as we have witnessed spreads much lower than current levels as recently as 2014 when they fell to 221 bps.

The strong gains in high yield bonds and sharp contraction in spreads over the past 13-months can be attributed to fundamental support on several fronts. First, the risk of corporate bonds defaulting is low. Default risk is reduced when the economy grows and expectations are for continued, and accelerating, economic growth. Second, there has been a huge recovery in energy and other commodity prices, which had driven spreads wider into early 2016. In addition, the lack of any source of stress has also kept volatility low, which has allowed the high yield bond market to remain buoyed despite being fully valued.


As we mentioned in our last Commentary, we continue to favor credit and thus are fully exposed to high yield in the Fixed Income Total Return portfolio. We do not expect to see the same surge in credit as we saw in 2016, but history shows spreads can remain tight for long periods of time without an economic downturn. We do not see any evidence of potential trouble for the economy as indicators we look at are in solid growth territory, including the Conference Board’s Index of Leading Economic Indicators (LEI), which recently surged to a new high, suggesting continued economic growth through the remainder of the year.

The below investment grade credit space still has a nice yield advantage over other fixed income sectors, and we are comfortable remaining allocated to credit, enjoying the yield advantage. We have dialed back our return expectations for the portfolio given the large gains over the past year. Given the run up in high yield bonds, tighter credit spreads, and lack of volatility in the market, we think low to mid-single digit return expectations are appropriate at this stage of the credit cycle.

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The S&P 500 measures the performance of the 500 leading companies in leading industries of the U.S. economy, capturing 75% of U.S. equities.
The Dow Jones Industrial Average is a stock market index that shows how 30 large publicly owned companies based in the U.S. have traded during a standard trading session in the stock market.
The MSCI EAFE Index is a free float-adjusted market capitalization index that is designed to measure the equity market performers of developed markets outside the U.S. and Canada.
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