Duration Trumps Credit in 2014: Long term Treasuries were the top performing asset class of 2014 in contrast to most expectations.
High Yields Get Bloodied: Primarily due to the collapse in energy prices, high yield bonds suffered at the end of 2014.
Credit Over Duration in 2015: We believe the U.S. economy will expand by about 3.0% in 2015, thus we favor credit risk over duration risk. A strengthening economy offers support to lower quality fixed income.
The major drivers of returns for the market in 2014 were a continued improvement in the U.S. economy, a commodity collapse, and the ending of quantitative easing in the U.S. The U.S. economy is accelerating and appears to be on solid footing to continue growing in 2015. Over the prior five quarters, the economy has averaged 3.1% growth, even when including the weather-related decline in the first quarter of 2014. In addition, in four of the past five quarters economic growth has been better than 3.0%. In the third quarter of 2014, the economy grew at the fastest pace in over a decade and the 5.8% unemployment rate is the lowest since June 2008. We expect the U.S. economy to grow by 3.0% in 2015, spurred along by strong momentum in the labor markets, gains in income and payrolls, favorable credit conditions, and improving manufacturing and services activity.
In contrast to most expectations coming into 2014, Treasury bonds performed very well. The 10-year Treasury yield dropped from 3.03 to 2.17%, and duration outperformed credit risk. In fact, long-term treasuries were the top performing asset class in 2014. In contrast, high yield debt came under pressure, especially in the fourth quarter as oil collapsed, with energy companies representing as much as 15% of the high yield indices. Credit spreads widened out to their highest levels since late 2012. The all-time low in credit spreads was in March 1994 at 211 bps. In June of this year credit spreads approached the all-time low and reached 221 bps on June 23rd. Spreads then surged to a high of 525 bps in mid-December, up 137%, before settling in at 444 bps at year-end. That compares to a rise from 316 bps to 768 bps, up 138% during the U.S. debt showdown in 2011. The outsized move in spreads sets up a potential nice entry point into high yields.
2014 was one of the weakest non-recession years for U.S. corporate credit. Looking back over the past 30 years, and excluding recession years, high yield spreads fared worse only twice: in 2011 on the back of the escalation of the European debt crisis and in 1998 on the back of the Russian default. Total returns paint a similar picture despite the meaningful tailwind from the rates market. With an annual total return of 2.45% in the Barclays High Yield index, 2014’s performance is the worst in the post-crisis environment. Also, excluding recession years, total returns were lower only three times over the last 30 years: in 1999 and 1994, which saw the Fed tighten monetary policy, and 1998 in the aftermath of the Russian debt crisis. The above episodes suggest that barring a recessionary scenario, episodes of underperformance often reverse. For example, after widening by 197 bps and 270 bps in 2011 and 1998, respectively, high yield spreads rebounded, tightening 207 bps and 90 bps in 2012 and 1999, respectively. The same pattern held true for total returns. The bottom line is that given our expectation that the U.S. economy expands by about 3.0% in 2015, we favor credit risk over duration risk as low recession risk should result in credit spread compressing.
Q4 Portfolio Analysis & Performance
- Eaton Vance Income Fund of Boston
- Lord Abbett High Yield
- iShares iBoxx High Yield Corporate Bond
- Barlcays High Yield Bond SPDR
Weakness in the fixed income credit markets that began to manifest in the third quarter continued into the fourth quarter. On October 10th the Fixed Income Total Return (FITR) portfolio became fully defensive, and the portfolio has taken a generally defensive stance since then amid some increased market volatility. Overall the defensive stance has overall served investors well as two thirds of the portfolio has been in U.S. Treasuries or cash since October. Since our exit of high yield bonds on October 10th, high yield prices have continued to weaken amidst volatility, largely due to the collapse in oil prices and fears about the fiscal capacity of energy companies. Overall we took a cautious stance because we never saw enough sustained high yield price strength, and thus we watched largely from the sidelines. However, one third of the portfolio did alternate between U.S. Treasuries and high yield bonds, moving into U.S. Treasuries and then back to high yield bonds twice during the quarter. Certainly our portfolio team was concerned with the FITR portfolio struggling with volatility during the fourth quarter, moving a portion of the portfolio in and out of high yield more than has been its usual pattern. We were reassured, however, that the portfolio remained at least two thirds out of the high yield bonds for most of the quarter during a time when volatility was elevated. Total Return is the objective of the portfolio, which includes both capital appreciation and income, but capital preservation is an important objective of the portfolio during times of heightened volatility. There was volatility and during the time that Treasuries had their largest upside move in over a decade, the portfolio was allocated to Treasuries. The primary goal of the FITR portfolio has always been to capture and/or avoid large moves in relative strength between high yield bonds, U.S. Treasuries, and cash. A generally defensive stance during the quarter certainly appears justified, and thus we believe the portfolio successfully fulfilled its mission. The top two contributors to return for the quarter were two high yield bond funds, Lord Abbett High Yield (LAHYX) and Eaton Vance Income Fund of Boston (EIBIX). The main high yield ETFs that the portfolio uses, the iShares iBoxx High Yield Corporate Bond ETF (HYG) and the Barclays High Yield Bond SDPR (JNK), were the top detractors.
We expect the U.S. economy to expand 3.0% in 2015 and with the unemployment rate approaching full employment, there is no reason for the Fed to keep interest rates at zero. Given the improving U.S. economic conditions the Fed is expected to begin hiking rates in the second half of the year, likely beginning in June. The entire yield curve has flattened and we expect that to continue into 2015 as the Fed rate hikes short-term rates and falling energy prices and inflation expectations keep a lid on long-term rates.
The high yield market has gotten bloodied of late, primarily due to the collapse in energy prices. While yields and spreads have backed up, broader based credit has remained firm, suggesting that this is an isolated problem due to the collapse of the energy market. Broadly speaking, after a noteworthy year for Treasuries and sub-par year for high yield bonds, we favor credit over duration risk as the strengthening economy offers support to lower quality fixed income. Credit spreads have recently backed up, with the Barclays Capital High Yield index ending the year trading at a 440 bps spread over the 10-year Treasury. Credit spreads do remain low historically and given continued economic growth we think they could stay low for an extended period.
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.
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