4Q 2018 — Taxable Fixed Income

Jamie Mullen
Senior Portfolio Manager
Eric Kazatsky
Portfolio Manager

In the second quarter of 2017, we wrote in our article “Back Where We Started”:

“The Fed is in an interest rate tightening mode. The initial hikes in the economic expansion don’t mean a whole lot until suddenly they do. With no history of unwinding a balance sheet of this size, the Fed will monitor if this in itself magnifies the rate hikes so far. Back where we started?

No, its 2017 and the adage ‘Don’t fight the Fed’ is back because here we go around again.”

With that statement in mind, the Fed’s policy finally started to matter and on December 3rd, 3-Year Treasury yields inverted to the 5-year Treasury. Ten days later, 2-Year Treasury bonds inverted to the 5-Year. The inversion dramatically increased equity volatility as the sell-off began on December 4th and made a closing low on December 24th. Adding to the pressure during the quarter were credit spreads on investment grade corporates, which widened out 40-50 basis points. High yield spreads widened as well but were remarkably orderly in their retreat.

Starting in January 2017, we had been positioning the portfolios in a bar-bell strategy in anticipation of the possibility of a flatter yield curve. When the curve inverted in early December, a large supply of bonds came into the market in the 3 to 4-year range. In our view, that area of the curve started to become undervalued. As some of our bonds matured in the fourth quarter, we reinvested slightly longer than the 1 to 2-year range we were investing in during the previous eight quarters.

We view the December 2018 volatility as a liquidity event and not a credit event as we witnessed in 2008. Since we invest in individual securities with a fixed maturity, investing in an environment of widening credit spreads is OK in our view. Ultimately, the bonds can mature and can result in higher yields for individual investors.

Source: Bloomberg, Ned Davis Research

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