Volatility has hit the fan
As 2018 began, higher volatility in the markets was a distant memory from before the 2008 financial crisis. Over the past decade, volatility became an asset class and the short volatility trade became profitable.
In January, stocks continued their optimistic march higher. The Fed was on autopilot to raise interest rates and bond yields increased at gradual pace. During this time, the increase in bond yields had no apparent effect on stock market valuations. But there were signs that something was about to change and that maybe outcomes could be unpredictable and volatile once again, and they came from an unlikely source, the National Football League.
As the sports world watched, everything seemed normal. The Philadelphia Eagles were the first number one seed in the history of the sport to be a home team underdog against any possible playoff opponent. Could it be any other way in Philly? Unpredictably, the Eagles walked into the Super Bowl. The Patriots were there as well. Anticipated was the timeworn script of a blowout win and a Brady comeback in the championship game. Then the predictable went awry. Brady had the greatest Super Bowl game of all time and had the ball with the chance to get the win. But Father Time said, “Not this time.” No more magic. The Eagles won the Super Bowl and unpredictable was about to become the norm.
On February 5th, a day after the Super Bowl, NYSE volatility as represented by the VIX Index would rise over 200% and would take with it investors’ money positioned to capitalize on the low market volatility. Suddenly — in a flash — volatility was back with a vengeance in most markets, and we would see it continue into the end of the first quarter.
Caught between a rock and a hard place
When stocks closed at an all-time high on January 26th, the 10-year Treasury closed at a yield of 2.66%. On February 5th, the day the VIX moved up over 200%, the 10 year traded at 2.70%. This is significant because it signaled a change in the marketplace. As volatility exploded and the S&P 500 dropped 114 points, bonds were no longer viewed as a safety asset. As stock volatility continued through February the 10-year bond yield peaked on February 21st at 2.95%.
With quantitative easing over and the Fed reducing its balance sheet, stocks may lose the Central Bank “put” protection. We are in the early innings of this Fed tightening or as they call it “normalization” of rates. Ultimately higher rates, higher cash flow, and reinvestment money is beneficial to savers and risk adverse investors. The concern for investors is as rates rise they could exude pressure on stock market valuations while bond prices continue to drop.
The Fed is on autopilot to raise rates an anticipated three times this year. After years of crisis management, Treasury bond yields out to three years are at levels not seen in the past nine years. As reported by Bloomberg, 2-year Treasury bond yields closed the quarter at 2.26%. This may not seem like much, but it is a welcome level to short-term riskless savers that were paid little to virtually no yield for years. Even Warren Buffet chimed in, stating he had purchased $100 billion in Treasuries because he was having a hard time finding value in stocks.
Rising short term rates are beneficial for savers but have started to cause some stress in the short end of the yield curve. The London Interbank Offered Rate or LIBOR is used to set rates on short term loans and has been rising significantly since December 2017. Why is this a problem? Well, it also rose prior to the U.S. financial crisis in 2008 and the European debt crisis in 2010. With memories of these events not far behind in the rear view mirror, bond traders have begun to focus on this benchmark. The realization is that it doesn’t take too much of a rise in LIBOR to cause some problems for borrowers when we factor in that trillions of dollars are priced according to this reference.
Get me out of this
There is no wonder volatility has returned to the market. Every time we pick up a newspaper there is a new headline — White House resignations, Mueller’s investigation, Russian election hacks, Kim Jong-un and North Korea, Stormy Daniels, tweets, Facebook and privacy rights. The list just keeps going on and on. Next up are tariffs and a potential trade war with China.
Warren Zevon said it a little differently in his song, but it is becoming clearer that “The ‘vol’ has hit the fan.”
Comments on Fixed Income Portfolios
Is the bond bull market over? This is the burning question. The answer is probably yes. The real question is what to do about it. The answer, in our opinion, is to be tactical within bond allocations and adjust accordingly. Would it make sense that if the Fed is going to actively manage interest rates, why wouldn’t you actively manage your fixed income holdings?
Treasury bonds out to three years are trading at levels not seen since 2008. One of the most important properties of a bond is that it matures and investors receive par or their principal value back. If the Fed stays on course and continues to raise rates over the next year, bond prices can move lower but you can reinvest coupon payments at higher interest rates. As you move through time, the bond value can recover, eventually converging to par value at maturity. Therefore, building par value in a portfolio is of paramount importance. This is done through systematic exposures and thoughtful allocations to various fixed income sectors, issuer coupons, and bond durations and maturity structures. The goal is a more thoughtful and tactical approach to fixed income management through all the portfolios we manage.
Taxable Bond Portfolio
We believe pricing in BB credits are approaching peak valuations. We have recently seen some rotation out of the fixed income space, which in turn has generated attractive yields and created some buying opportunities across the entire asset class.
Our general portfolio strategy has been to increase the credit quality of the investment grade allocation, and we are also looking to shorten overall portfolio duration. The portfolio’s high yield exposure is currently about 15% of the portfolio’s allocation. Our high yield exposure has been the beneficiary of several credit upgrades in the portfolio. The high yield asset class has been relatively immune to market volatility especially when compared to the performance of other equity and fixed income asset classes. Investment grade credits have been a drag on first quarter 2018 portfolio performance as we have observed widening spreads to Treasuries throughout the quarter.
Drilling into the fixed income sectors, banks and finance offerings have dominated the landscape, causing their spreads to widen. Technology is an area where spreads remain steady but prices have dropped, primarily due to rising interest rates. We have been actively barbelling the portfolio by overweighting both short-term and intermediate-term positions. Roughly one third of the portfolio is positioned in short-term paper. We are currently observing yields around 250 bps out to 14 months and further out on the curve at the 15 to 24 month range, paper is yielding around 300 bps. We think both areas of the yield curve present compelling yields and offer relatively limited duration exposure.
Our general focus in the tax-exempt fixed income strategy has centered on maintaining income, decreasing duration, and reducing our overall dollar value exposure (i.e., selling $115 bonds and buying $110 bonds). Throughout the first quarter, the strategy has focused on selling higher priced bonds with longer call dates at 8 to 10 years and buying lower priced bonds with shorter call dates at 5 to 7 years.
We recently started to see the effects of the Fed rate hikes as munis began the month of March trading more in line with, in our view, traditional metrics. What this means for muni investors is that we are now purchasing lower dollar priced bonds that are less sensitive to principal amortization compared to higher priced premium bonds.
Municipalities across the country are all facing the same risks, such as insufficient pension funding ratios and changes in the advanced refunding. We note that municipal bond insurance, as we see it, has been priced cheaply, and we have been looking to add these policies to our holdings as an effective way to enhance asset protection and to lower credit risk. We have purchased insurance on several general obligation names held throughout the strategy that we believe will act as an additional measure to preserve portfolio principal value.
Source: Bloomberg, Ned Davis Research
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