Portfolio Strategy

October 2, 2020

The Big Idea

Lessons from asset returns in the third quarter

Steven Abrahams | October 2, 2020

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.

The low interest rate volatility and tightening risk spreads that drove asset performance out of March kept right on driving after June, although with a little lighter foot on the pedal. Returns in credit handily beat the Treasury and agency markets. After considering return volatility, credit looked even better. But absolute returns and volatility dropped sharply from the second to third quarters. With an intermission for the election, credit looks likely to keep running. Allocators should consider a minimum weighting in Treasury debt, a modest overweight in MBS and a heavy overweight in corporate and structured credit.

Credit posted a leading performance again from June through September

With low, flat and relatively steady rates, and with Fed QE and fiscal stimulus continuing to support credit, credit again led the way in returns from June through September. Annualized returns in high yield corporate debt (18.3%) and leveraged loans (16.5%) topped the list followed by private CMBS (10.3%) and investment grade corporate debt (6.3%). ABS (3.2%) came next, trailed by agency CMBS (2.2%). Treasury debt (0.8%) and agency MBS (0.5%) brought up the rear.

Exhibit 1: Another quarter of strong returns for most credit in 3Q2020

Note: Based on daily returns in the Bloomberg Barclays indices and S&P/LSTA Leveraged Loan Total Return Index from 6/30/2020 to 9/30/2020.
Source: Bloomberg, Amherst Pierpont Securities

The returns reflected more movement in spreads than rates along with differences in spread duration across asset classes. Both 2- and 10-year Treasury rates moved by less than 3 bp from June through September (Exhibit 2). On the other hand, benchmark mortgage spreads tightened by 15 bp, investment grade corporate spreads by 17 bp and high yield spreads by 100 bp. Even though MBS and investment grade corporate debt tightened by similar amounts, the MBS duration of 2.14 years and the corporate duration of 8.69 years made the difference. The significant tightening in high yield and its duration of 3.74 years helped give it the top return spot.

Exhibit 2: Rates barely moved in 3Q2020 while risk spreads tightened

Source: Bloomberg, Amherst Pierpont Securities

Magnitude and volatility of returns dropped, but ratio improved

Performance from June through September roughly paralleled results from March through June but with lower absolute returns and less volatility. High yield, leveraged loans, investment grade corporate debt and private CMBS still topped returns from March through June, but with higher absolute returns and more volatility (Exhibit 3). High yield, for instance, printed an annualized 42.6% from March to June and 18.3% from June through September. Annualized volatility fell from 11.0% to 3.6%. Return for risk taken in high yield consequently improved from 3.87x to 5.11x.

Exhibit 3: Preceding 2Q2020 returns generally ran higher with more volatility

Note: Based on daily returns in the Bloomberg Barclays indices and S&P/LSTA Leveraged Loan Total Return Index from 3/31/2020 to 6/30/2020.
Source: Bloomberg, Amherst Pierpont Securities

The ratio of return to risk from June through September improved substantially for all areas of credit—high yield, private CMBS, ABS and leveraged loans—except for investment grade credit (Exhibit 4). The ratio for Treasury debt, agency MBS and CMBS also fell from June through September.

Exhibit 4: The ratio of return to risk improved for most of credit in 3Q2020

Note: Based on daily returns in the Bloomberg Barclays indices and S&P/LSTA Leveraged Loan Total Return Index from 3/31/2020 to 9/30/2020.
Source: Bloomberg, Amherst Pierpont Securities

Correlations point to diversification in MBS and speculative credit

Finally, correlations across asset returns from June through September showed a familiar pattern where Treasury debt, investment grade corporate debt and private and agency CMBS show relatively high correlations due to their generally longer durations (Exhibit 5). MBS shows an intermediate correlation with other assets. And high yield and leveraged loans show small or slightly negative correlations. The correlations point to the important diversifying impact of MBS and speculative grade credit.

Exhibit 5: Correlations show diversifying potential in MBS and speculative credit

Note: Based on daily returns in the Bloomberg Barclays indices and S&P/LSTA Leveraged Loan Total Return Index from 6/30/2020 to 9/30/2020.
Source: Bloomberg, Amherst Pierpont Securities

Allocations ahead

A few factors stand to make the stretch from September through December a little different from the largely Fed-led market since March:

  • The current low level of interest rates and the potential for a Democratic sweep of the November 3 elections makes for poor return prospects in Treasury debt. The market is very likely to view a Democratic sweep as a greenlight for much heavier fiscal spending, which would raise Treasury issuance or inflation or both. The longer part of the Treasury curve would reprice higher.
  • Uncertainty around the November 3 elections looks likely to hurt risk spreads until final vote counts roll in, whenever that might be. Although uncertainty before then could add to return volatility, significant widening should mark a buying opportunity. Resolution of the election, like resolution of most major uncertain events, should give a bid to risk assets.

Asset performance so far this year and the factors likely at work in the last quarter of the year point to some clear asset allocations:

  • Minimum Treasury allocation. Effective Fed control of the 5-year and shorter part of the Treasury curve leaves little room for performance. The flat curve leaves coupon as the main source of performance, and coupon is minimal. A Democratic sweep would pressure 10-year and longer rates. Return prospects look low to negative.
  • Modest overweight in agency MBS and CMBS. MBS and agency CMBS may widen to Treasury debt until election drama finishes, but resolution and Fed QE should ultimately reverse the widening. The special dollar roll in TBA MBS offers a clear source of excess return, and other pockets of these markets offer excess return as well.
  • Heavy overweight in corporate and structured credit. The continuing impact of QE, the hunt for yield by insurers and other investors and the prospects for fiscal stimulus should tighten spreads in investment and speculative grade corporate and structured credit. Investment grade corporate and structured credit should dominate any allocation here with smaller overweight positions in high yield and CLOs.

* * *

The view in rates

The risks in rates continue to tilt toward bearish steeping. That would come with any sign of fiscal stimulus before the November 3 election, given that expectations for now are low. A Democratic sweep would likely sharply raise expectations for fiscal stimulus in the near term and heavier federal spending in the long term. The Fed’s new framework for managing monetary policy—flexible average inflation targeting that only offsets shortfalls in employment—would likely contribute to the steeping. The Fed will likely only tighten if inflation shows up, not necessarily if unemployment runs too low. The new approach could see inflation run clearly above 2.0% and possibly above 2.5% for periods of time before the Fed might act to rein it in. That should pose the most uncertainty and most risk for longer maturities, pushing yields higher as the Fed holds the front of the yield curve down.

The view in spreads

The next leg of tighter spreads looks likely to come after the conclusion of the coming elections. That conclusion may land well after November 3. Spread compression took a holiday in August as spreads broadly moved sideways to wider and interest rate and equity volatility picked up, and that seems a reasonable expectation through November 3 and its aftermath. After final election results, however, an important element of uncertainty should resolve, and risk assets should rally. In the aftermath of elections, risk assets remain caught between Fed buying on one hand and heavy net supply of Treasury debt on the other. There is still fundamental risk in the most leveraged corporate balance sheets with corporate leverage going up through 2020, and only there might spreads continue lagging the rest of the market.

The view in credit

Fundamental credit remains as uncertain as the economy, and the lack of new fiscal stimulus increases risk for households and small businesses. The downside in leveraged credit has outweighed the upside since March, and the imbalance without fiscal stimulus looks likely to get worse. Many investment grade companies have stockpiled enough cash to survive protracted slow growth, but highly leveraged companies and consumers are at risk. Prices on some sectors of leveraged loans suggest distress ahead, despite the broad leveraged loan market completely recouping its losses in February and March. Elevated unemployment and delinquency rates in assets from MBS to auto loans show pressure on the consumer balance sheet. A rebound in growth in the third quarter should help, but the US has only recouped half of jobs lost since February. The next half looks likely to be harder.

Steven Abrahams

1 (646) 776-7864

sabrahams@apsec.com

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