Change is the Constant (4Q18)
Director of Fixed Income Research, Portfolio Manager
Portfolio Manager, Research Analyst
The adage that change is the one constant succinctly summarizes the financial markets in 2018. Placid environments, as we have written, invariably lead to more volatile and turbulent ones; although, timing is always unknown. The investment waters became decidedly more choppy last year, particularly in the fourth quarter, as the headline fears of the year (trade conflicts, slowing global growth, rising short-term interest rates and energy price declines) coalesced to a tipping point. December's decline in equity prices (the biggest monthly drop since 2009) gave it the dubious distinction of being the second worst December in history behind 1931. Credit spreads widened materially across all segments, particularly lower-quality bonds. The overall outcome for the year was a rare one, with cash winning the asset class performance derby as the vast majority of alternatives turned in negative returns.
The march higher of Treasury bond yields reversed course in the fourth quarter, ruining the predictions of many prognosticators who warned of a “perfect storm” and “bond bear market confirmed” for Treasuries in 2018. The chart below highlights the progression of select Treasury rates over the past quarter and year.
U.S. Treasury Yields (%)
Rates were up on the year but far less than many (maybe most) predicted. It was a good reminder for us that proclaiming absolute tops or bottoms in markets may make good headline material—but it is generally a loser's game. There is always someone who guesses right and garners a lot of attention, but typically they are a one-trick pony. Our goals will be to continue to focus on what we can know and remain disciplined in our investment process.
As mentioned, corporate bonds and other credit-sensitive securities had a tough year. They significantly underperformed Treasury bonds in the quarter and year as credit spreads widened, particularly for non-investment-grade or high-yield bonds. A broad measure of investment-grade corporate bond spreads, compiled by ICE BofAML, increased to 159 basis points as of December 31, up 46 basis points in the quarter and 60 basis points year over year.
The chart below, courtesy of Morgan Stanley, portrays total returns and excess returns as compared to U.S. Treasuries across quality segments of the corporate bond marketplace, from very high quality (AAA) to the lowest-quality segment (CCC). The chart shows in stark detail that there was virtually nowhere for fixed income investors to hide in 2018. Total returns were broadly negative, even worse when compared to Treasury bond alternatives as spreads widened, and 2018 returns were the worst overall since 2008.
2018 YTD Total & Excess Returns by Quality Bucket (%)
Source: Morgan Stanley
The next chart, also courtesy of Morgan Stanley, provides a little ray of light in an otherwise dreary landscape. It breaks out 2018 returns for investment-grade bonds across the maturity spectrum from short (1-3 years) to longer-term (10+ years) bonds.
2018 Investment Grade Total Returns (%)
Source: Morgan Stanley
While most investment-grade bonds posted losses in 2018, generally those that were shorter term (particularly 1-3 years) weathered the storm. Investors who have followed our portfolio updates over previous quarters will note that we have intentionally shortened the duration of our credit exposure as we viewed the risk/reward stacked against us in longer-term bonds. This decision to “take the market's temperature” over the course of months and quarters meaningfully helped all the Weitz fixed income funds, particularly Core Plus Income Fund, generate positive returns in a year where such results were scarce. The chart below shows how Core Plus Income Fund has performed since its inception in 2014 compared to industry peers (click here for the most recent standardized returns).
Core Plus Income Fund Scorecard
Total Return Comparison (%) as of 12/31/18
Please see the Quarterly Commentaries for all funds for additional information regarding fourth quarter 2018 portfolio activity and current positioning. Our investment philosophy in fixed income is straightforward: we believe the key to winning is not losing. Permanent losses of capital are a bane to long-term compounding—and especially so in fixed income investing. We avoid making bold or specific predictions about the direction and pace at which interest rates or credit spreads might move in the future. Caution has arguably always been our calling card in managing fixed income assets. As investors, we want to be appropriately compensated for any risks we assume. We are index agnostic and prefer to concentrate in our best ideas—those that we believe offer attractive risk-adjusted returns, taking into consideration the general level of interest rates and the credit quality of each investment.
Time will tell, of course, whether the recent widening of credit spreads is the beginning of something more ominous or simply a scene out of the Institute for the Very, Very Nervous from the Mel Brooks classic comedy High Anxiety (1977). Either way, we view volatility, and the fear that sometimes accompanies it, as the investor's friend—particularly when it results in a disconnect between price and value. We look forward to taking advantage of any valuation disparities that may develop in 2019 and hope to continue to earn your investing trust.
performance is not a guarantee of future results. All investments involve risks,
including possible loss of principal.
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 date of publication,
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
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strategy. Investment decisions should always be made based on an investor›s
specific objectives, financial needs, risk tolerance and time horizon.