July 15, 2020 The Elephant in the Marketplace Download PDF Tom Carney, CFA Vice President, Co-Head of Fixed Income, Portfolio Manager × x Tom Carney, CFA Vice President, Co-Head of Fixed Income, Portfolio Manager Core Plus Income Fund (Since July 2014) Nebraska Tax-Free Income Fund (Since January 1996) Short Duration Income Fund (Since January 1996) Ultra Short Government Fund (Since January 1996) Investment industry experience since 1982 Tom joined Weitz Investment Management in 1995 as an equity trader. He was promoted to co-portfolio manager in 1996 and to portfolio manager in 1999. Prior to joining the firm, Tom held several positions at Chiles, Heider & Co., Inc. Previously, he was a municipal securities professional with Smith Barney. Tom has a bachelor's in finance from the University of Nebraska Omaha. Close Nolan P. Anderson Vice President, Co-Head of Fixed Income, Portfolio Manager × x Nolan P. Anderson Vice President, Co-Head of Fixed Income, Portfolio Manager Core Plus Income Fund (Since July 2014) Short Duration Income Fund (Since July 2017) Ultra Short Government Fund (Since December 2016) Conservative Allocation Fund (Since July 2021) Investment industry experience since 2004 Nolan joined Weitz Investment Management in 2011 as a fixed income research analyst. In 2014, he was promoted to portfolio manager. Prior to joining the firm, Nolan performed financial modeling and due diligence on leveraged buyout transactions for Wells Fargo Bank. Previously, he worked for Woodmen of the World Life Insurance Society. Nolan has a bachelor's in real estate and land use economics, and an MBA from the University of Nebraska Omaha. Close We once again find ourselves at the midpoint of another year, and what a half-year it has been in the markets. If Rip Van Winkle had gone to sleep on January 1, woke up on July 1 and saw the S&P 500 down only 3% for the first six months, he might have surmised not much had happened so far in 2020. But as we are all aware, that vantage point does not even begin to tell the story of the past six months. The first half of 2020 contained an all-time high for stocks, a global pandemic that precipitated a near worldwide economic lockdown, the deepest recession since the 1930s, new unemployment of more than 20 million Americans, the sharpest/quickest bear market drop in history, and a subsequent market rally that will also go in the record books. It witnessed unprecedented government (both monetary and fiscal) response to meet the near economic winter caused by the lockdown. And the partial economic reopening in the second quarter has caused some to wonder if the recovery might resemble a V-shape or Nike swoosh (stairstep) instead of an elongated W or a dreaded L. Overall, the second quarter was a near inversion of the first quarter as stock and bond (particularly corporate and other credit-sensitive) prices recovered. Weitz equity and balanced funds registered strong gains in the second quarter, recovering a large portion of the first quarter's declines. Please see Wally and Brad's Value Matters and the Portfolio Managers' equity and balanced funds' commentaries for detailed analyses. Weitz Core Plus Income, Short Duration Income and Nebraska Tax-Free Income Funds also delivered strong returns in the second quarter, more than erasing the first quarter's declines. This has resulted in solid year-to-date investment performance, particularly for our Core Plus Income Fund. More details about contributors to performance can be found in the fixed-income funds' commentaries. Fixed-Income Market Update The graph below shows the changes of select Treasury rates over the past quarter and year. U.S. TREASURY YIELDS Source: Bloomberg The Treasury curve steepened in the second quarter as shorter rates (2-, 3- and 5-year) continued their march to zero while longer rates (10- and 30-year) rose modestly. The Federal Reserve (Fed) did not raise the federal funds rate during the quarter (leaving rates near zero) — but in statements and public appearances by Fed chair Jerome Powell and other committee members, the message has been clear. During a June press conference, Powell said “We're not thinking about raising rates. We're not even thinking about thinking about raising rates.” The market is growing increasingly comfortable/confident that rates will stay low through 2022 as the “dot plot” of Fed committee members' rate expectations show little dissent about keeping rates anchored at zero for at least that long. Spreads on corporate bonds rallied (declined) meaningfully in the second quarter, leading to strong outperformance compared to U.S. Treasury bonds. A broad measure of investment-grade corporate bond spreads, compiled by ICE BofAML, declined by nearly half in the quarter — from 305 basis points as of March 31 to 160 basis points on June 30. The chart below depicts the path of investment grade credit spreads for the past five years (blue line) against the one-year (orange) and five-year (gray) averages. INVESTMENT GRADE CREDIT SPREADS Source: Federal Reserve Economic Data (FRED) - St. Louis fed Overall, corporate bond credit spreads have meaningfully retraced the large spike upward that peaked in March of this year. Credit spreads remain above where they have been over the last five years, but coupled with very low 'base' rates (U.S. Treasury) on which nominal returns are set, forward returns on offer for corporate bonds are reaching (or have reached) all-time lows. An example of the return dilemma fixed-income investors currently face (higher risk with lower returns) can be seen in the Bloomberg Barclays US Aggregate Bond Index (one of the broadest, most widely followed fixed-income indexes) and a few of its key component segments (U.S. Treasuries, mortgage-backed securities, and corporate bonds). As of June 30, the US Aggregate Index's yield-to-worst (a measure of forward returns) of 1.25% and duration (a measure of interest rate sensitivity) of over six years are at/near record levels (i.e. lows for forward returns and high interest rate risk via duration). Yield to Worst Spread Duration U.S. Treasuries 0.50% +0 7.15 Mortgage-Backed Securities 1.36% +70 2.07 Corporate Bonds 2.15% +150 8.54 US Aggregate Index 1.25% +68 6.04 On a slightly more positive note, the chart below provides a near 25-year view of U.S. investment-grade corporate bond spreads when compared against the yield-to-worst. Courtesy of historic ultra-low U.S. Treasury interest rates, the added return for investors to own corporate (or other credit-sensitive) investments relative to “risk-free” U.S. Treasuries is at a multi-year high. US IG INDEX SPREAD AS A % OF YIELD TO WORST Source: CreditSights, Inc., ICE BOofAML Indecies Outlook — crediting the “elephant” in the room In a June testimony to the Senate Banking Committee, Fed Chair Powell downplayed the significance of the Fed's recent decision to begin buying corporate bonds. “I don't see us as wanting to run through the bond market like an elephant, doing things and snuffing out price signals,” said Powell. “We just want to be there if things turn bad in the economy.” The monetary goals of the Fed have always played a key role in credit markets and the economy via its two-fold mission of price stability and full employment. As a result of the economic downturn of 2007 to 2009 (“Great Recession”) the Fed took actions to expand its powers/reach through quantitative easing programs (central bank purchases of longer-term securities in the open market). During the COVID-19 crisis, the Fed put its powers on steroids. Besides using programs from the Great Recession, the Fed is now directly involved in buying and accumulating corporate bond exchange-traded funds (ETFs) and individual corporate bonds. The Fed has long jawboned the markets through its press releases and public discourses — but despite its desires to not be that pachyderm, it has become the elephant in the room. It has squashed interest rate levels and volatility for the foreseeable future. It has banished the bond market vigilantes — those of us who keep the marketplace functioning by sniffing out prices that are too high or too low — to some sort of financial market Purgatory. And its direct purchases of corporate bonds (via its Primary and Secondary Corporate Credit Facility) may not have snuffed out price signals — but it clearly has given investors the 'all clear' signal. Where does that leave fixed-income investors today knowing there is a nearly insatiable buyer (elephant) now present in the marketplace? Challenged, for sure, if your investable universe consists primarily of the segments of the marketplace being directly impacted by the Fed's checkbook. Our fixed-income funds have broad, flexible mandates that, we believe, allow us to navigate the increasingly lower return environment by identifying investment opportunities less influenced by Fed intervention (such as structured products). Our goals remain the same. Namely, to preserve capital, maintain a strong liquidity position, understand evolving risks and opportunities, selectively take advantage of favorable risk/reward opportunities, and conduct consistent/thorough credit surveillance. We remain ready to take advantage of any further valuation disparities that may develop, and we hope to continue to earn your trust. /sitefiles/live/documents/FIInsights/2Q20_Fixed Income Insights.pdf The opinions expressed are those of Weitz Investment Management and are not meant as investment advice or to predict or project the future performance of any investment product. The opinions are current through the publication date, are subject to change at any time based on market and other current conditions, and no forecasts can be guaranteed. This commentary is being provided as a general source of information and is not intended as a recommendation to purchase, sell, or hold any specific security or to engage in any investment strategy. Investment decisions should always be made based on an investor's specific objectives, financial needs, risk tolerance and time horizon. Data quoted is past performance and current performance may be lower or higher. Past performance is no guarantee of future results. Investment return and principal value of an investment will fluctuate, and shares, when redeemed, may be worth more or less than their original cost. All investments involve risks, including possible loss of principal. Please visit weitzinvestments.com for the most recent month-end performance. Effective 12/16/2016, the Ultra Short Government Fund revised its principal investment strategies. Prior to that date, the Fund operated as a “government money market fund” and maintained a stable net asset value of $1.00 per share. Performance prior to 12/16/2016 reflects the Fund›s prior principal investment strategies and may not be indicative of future performance results. Effective 12/16/2016, the Short Duration Income Fund revised its principal investment strategies. Since that time the Fund has generally maintained an average effective duration between one to three and a half years. Prior to that date, the Fund maintained a dollar—weighted average maturity of between two to five years. Performance prior to 12/16/2016 reflects the Fund›s prior principal investment strategies and may not be indicative of future performance results. Portfolio composition is subject to change at any time. Current and future portfolio holdings are subject to risk. Definitions: Investment Grade Bonds are those securities rated at least BBB- by one or more credit ratings agencies. Non-Investment Grade Bonds are those securities (commonly referred to as “high yield” or “junk” bonds) rated below BBB- by two or more credit ratings agencies. Yield to Worst (YTW) is the lowest potential yield that can be received on a bond portfolio without the issuers actually defaulting.