The Elephant in the Marketplace
Director of Fixed Income Research, Portfolio Manager
Portfolio Manager, Research Analyst
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
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.
the second quarter was a near inversion of the first quarter as stock and bond
(particularly corporate and other credit-sensitive) prices recovered.
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
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.
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
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
||Yield to Worst
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
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 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.
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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.