The third quarter was a volatile quarter for equity and credit markets alike. The global equity markets suffered a long-awaited correction and that was accompanied by lower quality credit suffering its largest drawdown since the U.S. debt downgrade in 2011. The Barclays High Yield Index fell 6.3% from its high on May 29th through the end of the quarter. As high yield debt has come under pressure, credit spreads (yield on high yield bonds – 10-year Treasury yield) have widened out to 598 basis points at quarter end, their highest level in three years. For the quarter, the Barclays High Yield Index declined 4.86% while the Barclays Aggregate Bond Index rose 1.23%. It was a quarter in which the risk-off trade was prevalent. However, the normal risk-off benefactors, including Treasury bonds, advanced but not as aggressively, given their low yields and concerns about the Federal Reserve and looming rate hikes.
Most investors expected the Federal Reserve to finally pull the trigger and hike rates in September. However, the Fed decided to punt again and left the overnight bank lending rate unchanged. We are of the opinion it would be better to rip the Band Aid off and hike rates. The Fed has kept rates artificially low for too long and that has forced investors to assume more risk to gain yield, and it has distorted asset valuation. A problem now is not if or when the Fed will raise rates, it is the paralyzing discussion about when they will eventually raise rates.
It’s one thing to acknowledge that rates are likely to stay low because we are in a deflationary world, but it is another thing altogether to leave rates zero bound. Lower or near zero rates and QE were necessary at the beginning of the Great Recession, but the Fed has now created an environment where the market needs low rates like a junkie needs his next fix. A legitimate fear is that the longer the Fed postpones normalization, the more difficult the return to normal markets is going to be. The Fed needs to rip the Band Aid off sooner rather than later.
Third Quarter Attribution
Early in 2015, on January 12th, the Fixed Income Total Return portfolio allocated 100% to high yield bonds using a combination of high yield mutual funds and ETFs. Our models remained positive towards high yield bonds through the second quarter, but as the third quarter progressed, the weakness that was isolated in the high yield energy sector spread into the broader high yield market. As a result, our models turned and the portfolio became 100% defensive on July 28th. The portfolio sold its high yield bond positions entirely, and now owns intermediate-term U.S. Treasuries. The move turned out to be timely, as the portfolio was completely defensively invested during the market turmoil in August. While the S&P 500 endured a 12% decline over four days in August, the portfolio produced slight gains in its defensive Treasury position. High yield bond spreads continue to widen as September comes to a close. We see no particular end to the fear that has gripped credit markets since May. Here are some additional developments in the portfolio during the quarter:
- The portfolio currently owns two U.S. Government ETFs, the iShares 3-7 Year Treasury ETF (IEI) and the iShares 7-10 Year Treasury ETF (IEF). The resulting duration of the portfolio is just over six.
- Leading into September’s Fed announcement (in which they kept rates unchanged), our models nearly produced a neutral signal that would have allocated a third of the portfolio to each of high yield bonds, Treasuries, and cash. The Fed’s announcement led to a stock market and high yield bond selloff, and our models have returned to their maximum defensive position.
- Many of the smaller explorers and producers in the high yield energy space face bank refinancing issues in the fourth quarter. Defaults are considered likely, particularly for smaller players. We believe that may lead to an extreme in fear and sentiment and could create a tradeable bottom.
- The portfolio’s two Treasury ETFs were the top contributors on the quarter, while the Barclays High Yield Bond SPDR (JNK) and Neuberger Berman High Income (NHILX) were the top detractors.
Credit spreads have widened to their highest level in three years and, in our opinion, have set the stage for a potentially nice entry point back into high yield. That hasn’t happened yet, but it could as we move further into the fourth quarter. The yield on the Barclays High Yield Index ended the third quarter at 8.04%. Yields on below investment grade corporate debt are attractive on both an absolute basis and relative to other fixed income sectors. Meanwhile, the 10-year Treasury yield hovers near its recent lows at 2.06%, as Treasuries have benefitted from a risk-off environment and the Fed’s delay in hiking rates. If there is any stabilization in the energy market, it should lead to better performance in credit given the yield advantage of high yield debt, the resiliency of the U.S. economy, and the fact that we are now entering into a seasonally strong period for risk assets.
Past performance is not indicative of future results.
This is not a recommendation to buy or sell a particular security. Please see attached disclosures.
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.
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.
The MSCI Emerging Markets Index is a free float adjusted market capitalization index that is designed to measure equity market performance in the global emerging markets.
The Russell 3000® Index measures the performance of the 3,000 largest U.S. companies based on total market capitalization, which represents approximately 98% of the investable U.S. equity market.
The CBOE Volatility Index (VIX) is a forward looking index of market risk which shows expectation of volatility over the coming 30 days.
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Barclays U.S. Government/Credit Bond Index measures the performance of U.S. dollar denominated U.S. Treasuries, government-related & investment grade U.S. corporate securities that have a remaining maturity of greater than one year.
The Barclays U.S. Aggregate Bond Index covers the U.S. investment-grade fixed-rate bond market, including government and credit securities, agency mortgage pass-through securities, asset-backed securities and commercial mortgage-based securities. To qualify for inclusion, a bond or security must have at least one year to final maturity and be rated investment grade Baa3 or better, dollar denominated, non-convertible, fixed rate and publicly issued.
The B of A Merrill Lynch U.S. High Yield Index tracks the performance of below investment grade U.S. dollar-denominated corporate bonds publicly issued in the U.S. domestic market.
The Barclays 7-10 Year Treasury Index tracks the investment results of an index comprised of the U.S. Treasury bonds with remaining maturities between seven and ten years.
The Barclays 20+ Year Treasury Index tracks the investment results of an index comprised of the U.S. Treasury bonds with remaining maturities greater than twenty years.
The Barclays Long-Term Year Treasury Index tracks the performance of the long-term U.S. government bond market.
The Barclays U.S. Corporate High-Yield Index covers the USD-denominated, non-investment grade, fixed-rate, taxable corporate bond market. Securities are classified as high-yield if the middle rating of Moody’s, Fitch, and S&P is Ba1/BB+/BB+ or below.
The Barclays U.S. Treasury Bond Index is an issuances-weighted index measuring the performance of the U.S. Treasury bond market, one of the largest and most liquid government bond markets in the world.
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