Bob Brown’s key takeaways
- Monetary policy will be dependent on sustainable trends in economic data.
- Despite the recent uptick in rate volatility, many segments of the bond market have seen investor demand.
- The U.S. economy has been resilient, but the state of the recovery remains fragile.
- Investment-grade bonds should continue to provide strong protection from unexpected risks or macro events.
Looking back, as we headed into the third quarter, market expectations were building that the Federal Reserve would soon begin to taper its massive bond-buying program, also known as QE3. As such, interest rates rose throughout July and August, as most market participants were forecasting that tapering would begin to take place at the end of September.
No taper after all
Surprising to the market, but consistent with our view, the Fed ended up deciding not to taper after all, and instead adopted a “wait and see” approach. It now appears that the future direction of monetary policy is going to be dependent on more sustainable trends in economic data.
The Fed’s decision reflected concerns about a number of factors, including less-than-favorable labor market trends, low inflation readings, and sluggish economic growth not only in the United States, but in other areas around the globe. In addition, mortgage rates in the U.S. are nearly 100 basis points (1%) higher today than they were at this point last year. Given the importance of the housing market to the U.S. economy, the Fed recognizes that higher mortgage rates could end up reversing the positive trends we have seen in the housing market and dilute the impact it could have on an economic recovery.
Bond market rallied
Bond market returns have been significantly impacted by these developments. Prior to the Fed’s decision to delay tapering, some of the worst-performing bond sectors included those that are most sensitive to U.S. interest rates, including U.S. Treasuries, Treasury inflation-protected securities (TIPS), and mortgage-backed securities, as well as bonds tied to emerging markets, which fared poorly due to negative trends in capital flows. After the Fed’s surprise announcement at the end of the quarter, all these sectors rallied.
Interestingly, despite the recent uptick in rate volatility, many segments of the bond market have continued to see demand from investors. For example, driven by the largest corporate deal ever—a $49 billion sale by Verizon Communications—more investment-grade corporate bonds were sold in September than in any other month in history. We continue to see companies in the U.S. take advantage of the ability to borrow at relatively attractive yields, driven to a large extent by the Fed’s accommodative policies that have been in place over the last few years.
Resilient but fragile
From a valuation standpoint, spread levels across many risk assets declined in the quarter, as market participants became convinced that the continuation of a dovish Fed should put a cap on volatility—at least over the near term. So where do we stand today? Spread levels are significantly lower than they were during the credit crisis, reflecting not only the tremendous support that has been provided by the Fed, but also improvements that have taken place from a fundamental perspective. For example, the corporate credit market has benefitted from the fact that corporations are carrying historically high levels of cash on their balance sheets. The improving trends in the residential and commercial real estate markets have positively impacted securitized sectors such as mortgage-backed securities, commercial mortgage-backed securities, and asset backed securities.
Today, then, I would characterize valuations in fixed income as being balanced in light of the many uncertainties that still exist, as global market volatility is still very much a factor. While the U.S. economy has proven to be resilient, the state of the recovery remains fragile. Meanwhile, outside the U.S., we have seen that many emerging markets have shown signs of slowing, and in Europe, although the eurozone has just recently emerged from recession, economic activity is forecasted to stay low while many political and structural reforms still need to be resolved.
Given these challenges, I would say it is likely that high levels of volatility could continue to play a role in the marketplace. In that environment, investment-grade bonds should continue to provide strong protection to unexpected risks or macro events. As bond managers, we will maintain focus and discipline on our core investment tenets—seeking attractive levels of risk-adjusted returns through rigorous fundamental credit and quantitative research, individual security selection, and top-down macroeconomic analysis.