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Fidelity® Strategic Disciplines

 

A Message From the Portfolio Management Team

BRECKINRIDGE CAPITAL ADVISORS, INC.* — March 31, 2020



Q1 | 2020 HIGHLIGHTS

COVID-19 DROVE INVESTORS TO ACT

  • As the world adjusted to the economic effects of the COVID-19 pandemic, markets experienced periods of intense volatility, reflecting severe liquidity strains.

MUNICIPAL BONDS WITNESSED DRAMATIC REVERSALS

  • Earlier in the quarter, municipal bonds traded at historically low yields, with expensive municipal/Treasury ratios and a favorable credit environment.
  • Investor sentiment changed in March as concerns rose surrounding the COVID-19 outbreak. Yields skyrocketed, ratios became cheaper, and the market revealed growing concerns about credit quality.

POLICY AND LEGISLATION CALMED MARKETS

  • The Federal Reserve’s actions to address market liquidity, and the passage of the $2 trillion CARES Act, provided stability by the end of the quarter.
  • Performance for the index1 was essentially flat for the quarter, with a total return of 0.0%.

Market environment: Investors responded to COVID-19 pandemic

Yield Curve Inversion

  • A yield curve inversion occurs when long-term debt instruments have lower yields than short-term debt instruments of the same credit quality.

During the quarter, U.S. Treasury yields dropped by about 1.3% in the 2-, 5-, and 10-year ranges, and 1.1% in the 30-year range.2 The yield on the 10-year Treasury bond moved steadily lower in February, before the outbreak, finishing the quarter at 0.7%.3

The yield curve was inverted at the very short end in February before Treasury bills slipped into negative territory in March. Treasuries are often seen as a haven during times of market stress. They outperformed municipal bonds across the curve by a wide margin.4 Liquidity in the Treasury market was challenged at times in March. By quarter-end, steps taken by the Fed and Congress appeared to reassure investors and reduced market volatility. The yield curve steepened in response.

Chart Source: U.S. Department of the Treasury, as of 3/31/2020.

While municipal values experienced intense volatility, quarterly performance was flat

Municipal/Treasury Ratios

  • Municipal/Treasury ratios measure the difference between municipal and U.S. Treasury bonds of the same maturity. For example, if the yield on AAA-rated municipal bonds is 1.5% and the yield on the 10-year Treasury is 2.0%, the ratio is 0.75.
  • Lower ratios indicate that municipals are expensive compared with Treasuries.

Before the dramatic market movements that began in early March, municipal bonds were trading at historically low yields, with expensive municipal/Treasury ratios and a high-quality credit environment. An abrupt shift in investor sentiment as COVID-19 concerns escalated caused yields to skyrocket, ratios to surge upward, and credit-quality concerns to amplify.

The Fed’s action and the passage of the CARES Act provided some stability to the municipal bond market.

  • Yields finished the quarter unchanged at 1.1% for both the two- and five-year ranges.5
  • Yields were lower across 10- and 30-year maturities, finishing at 1.3% and 2.0%, respectively.6
  • New issue supply closed the quarter at $89.5 billion, a 13.0% increase compared with the same quarter last year.

The economic effects of pandemic responses are significant

The economic effects associated with responses to the spread of the virus have been acute. U.S. jobless claims spiked in the last two weeks in March with nearly 10 million recorded. Gross domestic product projections deteriorated, with full-year 2020 estimates ranging from –1.0% to –6.0%.7

Municipal credit conditions likely will deteriorate

Entering 2020, municipal credit fundamentals were broadly stable. But now, the market environment may challenge credit fundamentals as issuers seek to manage through a period of reduced revenues across sectors. Ratings downgrades are likely. However, financially strong issues often maintain surplus reserves intended to mitigate the financial impact caused by a period of decreased revenues.

Breckinridge favors a defensive positioning and high-quality investments

ACCOUNT SUMMARY

  • Before the recent market volatility resulting from the COVID-19 outbreak, Breckinridge had defensively positioned client accounts by reducing exposure to credit risk.
  • Breckinridge continues to favor higher-quality bonds. They are more likely to hold their value, or even benefit, during periods of uncertainty.
  • Breckinridge believes that the economy is likely to contract. Their defensive positioning and bias toward quality investments remain in line with their current economic outlook.

Breckinridge believes that the economy is likely to contract and that credit conditions may deteriorate. Therefore, their ongoing defensive positioning and bias toward quality investments remain in line with their current economic outlook. Going into the COVID-19 crisis, Breckinridge had defensively positioned their portfolios by reducing exposure to credit risk. If quarantines or shelter-in-place orders last for months, Breckinridge believes that broader credit downgrade risk is likely to increase.

Investment-grade bonds may add stability during periods of market volatility.

  • Breckinridge favors higher-quality bonds. They are more likely to hold their value, or even benefit, during periods of uncertainty.
  • Breckinridge believes that AAA and AA rated bonds may hold more value. This is due to the increased potential for deteriorating credit in other investments.
  • In recent years, the additional yield from lower-quality bonds has narrowed. Therefore, Breckinridge’s bias toward quality investments has grown stronger.

Today, Breckinridge remains very comfortable with the overall quality of all their investments.

The Breckinridge strategy duration remains neutral to slightly longer relative to the index. As the economy contracts and risk assets like high-yield bonds potentially decline, Breckinridge expects that demand is likely to remain strong for high-quality fixed income securities like municipal bonds, hence Breckinridge’s slightly longer duration.