Bonds Surprise to the Upside: Contrary to expectations, bonds have performed better than predicted so far this year.
Liquidity Abounds: While the Fed tapered their bond buying program throughout the quarter, the government reduced its debt. As such, the Fed is buying a larger share of treasuries today than at any other time during Quantitative Easing (QE).
Long Term Outlook: The market may not be pricing in the full extent of the rate hikes we believe are coming. The Fixed Income Total Return portfolio continues to favor credit over duration risk.
Coming into the year almost everyone believed interest rates would rise from an already very low rate environment. However, contrary to consensus expectations, bonds have performed better than predicted so far this year. For the quarter and year-to-date periods, both treasuries and high yield bonds posted gains. For the quarter, the Barclays Aggregate Bond index gained 2.04%, Barclays 7-10 Year Treasury index was up 2.49%, and the Barclays High Yield index posted a 2.41% gain. Year-to-date the Barclays Aggregate Bond index is up 3.93%, Barclays 7-10 Year Treasury index is up 5.20%, and the Barclays High Yield index has gained 5.46%. The market was positioned for rising rates, but the 10-year Treasury rate has actually fallen from 3.03% at the beginning of the year to 2.52% at the of June.
Yields have fallen against expectations. There are several reasons why we believe rates have come in: international influences, less debt outstanding, and renewed flows into bond funds. Much of the reason for yields coming down in the U.S. is globally driven. The deflationary risks in Europe and the move by the ECB to stimulate a stagnating economy may have affected European yields thereby influencing other markets including benchmark U.S. rates. Major European yields collapsed during the quarter. In Germany, Spain, and Italy, 10-year yields closed the quarter at 1.25%, 2.66%, and 2.85% respectively. In addition, the 10-year rate in France and Spain hit record lows during the quarter. With periphery European rates so low, U.S. yields had no choice but to be dragged along for the ride lower.
The market is still awash in liquidity fueled by the Federal Reserve (Fed). During the quarter the Fed did taper their bond buying program at each of their FOMC meetings and are now buying $35 billion of bonds a month, down from a peak of $85 billion at the end of last year. Even so, the Fed is still purchasing a larger share of treasuries today than at any other time during Quantitative Easing (QE). The reason for this is that the government is issuing debt at a slower pace than the Fed is tapering QE. Over the last two months the amount of outstanding Treasuries has been reduced by about $100 billion while the Fed was in the market buying $58 billion. The government was reducing debt at the same time the Fed was buying Treasuries from the shrinking supply. On a six-month rolling basis the Fed has purchased 73% of new Treasury issuance. That leaves very little for normal investors to buy and we believe provides another good reason that yields fell during the quarter. The benchmark 10-year Treasury fell from 2.72% to as low as 2.44%, before settling at 2.52% to end the quarter.
Q2 Portfolio Analysis & Performance
- BlackRock High Yield Bond
- Eaton Vance Income Fund of Boston
The credit markets have given investors a clear signal as to what to think about the report of first quarter GDP falling 2.9%: don’t worry about it! One would think that such a negative report would perhaps foreshadow recession and cause investors to flee risky assets, but that has not been the case in stocks or in fixed income. High yield bonds continue to perform well, and in our view their positive price action may indicate that investors as a group are simply not very concerned about the global economy for the near term. Spikes of violence in Iraq and Syria and higher oil prices have not been a deterrent so far, either. It is amazing what can happen when central banks around the globe coordinate to keep interest rates and volatility low. The Fixed Income Total Return (FITR) portfolio moved to a 100% fully invested position in High Yield Bonds nearly a year ago on July 18, 2013. The portfolio’s primary evaluation regarding which asset class to own involves comparing the relative strength of High Yield Bonds versus Treasuries. By that measure, high yield bonds remain very strong. From July 18, 2013 until June 30th of this year, High Yield Bonds as measured by the Barclays High Yield Bond SPDR (JNK) gained 8.13% while the iShares 7-10 Year U.S. Treasury ETF (IEF) gained 3.20%. The FITR model remains very close to new all-time highs. Our best forecast for the markets’ path this year predicts a more volatile and turbulent third and early fourth quarter but nothing close to a full blown bear market. As much as we believe in that forecast, the Fixed Income Total Return portfolio is not influenced by any forecast. It is only influenced by its model, which has been undeterred and very bullish. While we are always watchful for deterioration in credit conditions that might force us to become defensive, we see no evidence of any need to become cautious at this time.
The credit markets remain very stable with 10-year rates stuck in a range between 2.40% and 2.80%. This range will eventually be broken, and as we said in our Market Outlook for the year, we believe that yields should traverse higher before year-end. Investors have overlooked a disastrous report on first quarter economic growth that had many calling an end to the five-year economic expansion. The economy contracted at a 2.9% annual pace in the first quarter as consumption plummeted. The combined GDP growth for the last four quarters fell from 2.6% to only 1.5% 10 year yields — lower than the trend of 2.0% for the last five years. That report was not even enough to push yields to new lows and in fact signs that the economy is improving may have led to the breakout higher in two-year Treasury yields. We find further confirmation that the economy is strengthening in the firming labor market. The economy has added an average of 231,000 jobs per month over the first six months of 2014 compared to an average of 185,000 jobs over the last six months of 2013.
At the current low levels of yields the market may not be pricing in the full extent of rate hikes that we believe are coming our way. Recent Fed member comments suggest that the long-term average overnight rate is 4.0%, and they expect full employment and their 2.0% inflation target to be hit by the end of 2016. If that is the case, going from effectively 0% to closer to their long-term average would mean that investors are underestimating both the timing and path of interest rates. Historically the Fed has waited about a year from its last easing to its first tightening. If the Fed keeps on its tapering path, it will be finished buying securities come November. That makes June or September of 2015 the most likely time to raise rates.
In the Fixed Income Total Return portfolio we continue to favor credit over duration risk as the strengthening economy may offer support to lower quality fixed income. Credit spreads are historically tight. At the end of June the Barclays High Yield index traded at a 231 bp spread over the 10-year Treasury and, given continued economic growth, spreads could stay low for an extended period as they did in the mid 90s.
The opinions expressed are those of Clark Capital Management Group Investment Team. The opinions referenced are as of the date of publication and are subject to change due to changes in the market or economic conditions and may not necessarily come to pass. There is no guarantee of the future performance of any Clark Capital investments portfolio. Material presented has been derived from sources considered to be reliable, but the accuracy and completeness cannot be guaranteed. Nothing herein should be construed as a solicitation, recommendation or an offer to buy, sell or hold any securities, other investments or to adopt any investment strategy or strategies. For educational use only. This information is not intended to serve as investment advice. This material is not intended to be relied upon as a forecast or research. The investment or strategy discussed may not be suitable for all investors. Investors must make their own decisions based on their specific investment objectives and financial circumstances. Past performance does not guarantee future results.
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