As 2018 came to close, volatility was in high gear and we closed with the following statement, “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.” Those words really came to fruition as the Fed shifted gears with three rate cuts during the year and provided year-end liquidity to apply salve or maybe gasoline to a risk-on market.
The quarter was highlighted by some credit upgrades in our BB holdings and bonds being called as issuers were able to refinance at favorable rates. To give you an example, a long-term BB holding of ours had remained a BB credit for years and in our view, was a value as we owned the 5.125% bonds due 2021 for the front end of our barbell strategy. An upgrade to Baa3/BBB- in October enabled the company to issue debt for 5 years at 2.80% and 10 years at 3.45%.
Returns in the quarter were driven by:
- Spread compression in investment grade corporate bonds
- Record low yields of BB credits in the portfolio
- Stable prices in our BB credits as several were called away, allowing us to just collect larger cash flow from the higher coupons versus investment grade
- Barbell strategy continues to perform in a favorable fashion versus the benchmark
2019 ends a banner year in the fixed income markets and we believe 2020 should be more challenging. Market watchers are concerned with an equity market trading over 19x earnings. As a fixed income manager, I am concerned with both investment grade and high yield spreads, which have been driven to the tightest level of the year by dawn of the new decade. We can navigate through credit shocks, and we can navigate through higher rates by using the barbell approach. But credit spreads widening can cause some underperformance at the start of that cycle.
With the roaring 20s ahead, the question is if central banks finally create an “inflation” hangover this decade. Having lived through the 1970s and early 80s, I saw the effects of inflation on a household budget. Inflation is a tax on future spending, but what is left to go up in price? College? Healthcare? Energy? That doesn’t even include the expenses of cell phones and internet bills, which were never part of a 1970s household budget.
People generally have more financial resources today and higher interest rates would be welcome to most households awash in cash from equities and savings over the last few years. However, we saw what happened when the 2-year Treasury moved to 3% last December to the equity market—a sell-off ensued.
The roaring 20s lie ahead. The punch bowl has been spiked for a decade now. Central banks have not only intervened time and time again, and they are intertwined with the economy now more than ever—but can they ever really stop? As tactical managers, we will assess the markets and adjust our portfolios accordingly to what lies ahead. Wild Cherry had it right in the late 1970s, C’mon Fed boys, lay down and boogie and play that funky stimulus till you……?