As we head into the dog days of summer, the Fed has warned the markets that balance sheet reductions will begin, “relatively soon.” The European Central Bank and Bank of Japan continue their buying spree, driving global fixed income buyers to the relatively high yields available in the U.S. The international demand is keeping domestic yields lower than expected given the outlook for further Fed increases over the next couple of years. The Fed is continuing to prepare markets for the gradual reduction of its $4.6 trillion balance sheet (by ending the reinvestment of maturities in its U.S. Treasury and mortgage-backed security holdings). Since this process is potentially disruptive, expect the Fed to carefully monitor market behavior before resuming rate-hikes both prior-to and during the run-off. Additionally, the market should begin to speculate whether Janet Yellen will be reappointed or ousted when her term ends in February of 2018. Such conjecturing could be a source of volatility throughout the fall.
A combination of several possible factors have pushed equity volatility ,as measured by the CBOE Volatility Index® (VIX), and fixed income volatility, as measured by the Merrill Lynch Option Volatility Estimate Index (MOVE), to their lowest levels in 25 years. First, volatility has become its own asset class. Selling volatility (i.e., selling options) has recently earned investors solid returns. However, economic logic holds that as the number of investing strategies selling volatility increases, the price investors are going to pay to buy falls, thereby reducing volatility. This strategy is risky because a large move in volatility could wipe out many months, if not years, of performance.
The second possible reason for subdued levels of volatility is the belief that the Fed would come to the rescue if a financial shock hit the markets. Investors may believe this “Greenspan/ Bernanke Put” is still a viable option and are not concerned about large drawdowns, thus elevating risk-taking. Whatever the reason for low volatility, it is our belief that this level of market apathy will dissipate soon.
Credit market risk premiums moved tighter for most of the second quarter. Continued shareholder-friendly activity and rumors of leveraged buyouts highlighted the importance of credit selection. The Bloomberg Barclays U.S. Corporate Bond Index® spread over comparable Treasuries narrowed by 9 basis points (bps), which lead to a total return of 2.54% and an excess return versus treasuries of 1.43%. Financial bonds slightly underperformed Industrials as the yield curve flattened, thus reducing interest income for banks and insurance companies.
Oil prices continued to fall into the second quarter as U.S. shale production rose and Libya/ Nigeria had large rebounds in production. West Texas Intermediate (WTI) oil traded down to $42.53 during the quarter, which was the lowest level since last November. As a result, energy issues underperformed but the reaction was subdued compared to previous falls in oil prices.
Energy company balance sheets are in better shape, and the marginal cost of production has fallen to levels that allow some companies to make an economic return at $35 oil prices. However, spreads would widen if oil prices were to fall below $40 for an extended period of time.
The ongoing demand for risk assets, driven by global central bank monetary policy, has produced near all-time tight spreads in the credit sector. We prefer to focus on new purchases in higher quality, shorter maturity credits that can provide protection if volatility returns. Additionally we are buying well-structured agency mortgage-backed securities and high coupon, short call, taxable municipals that may perform well if the Fed normalizes interest rates. We are avoiding tax-exempt municipal bonds because of rich valuations, and are instead opting for taxable alternatives that currently offer higher after-tax yields.
Bonds are subject to certain risks including interest-rate risk, credit risk and inflation risk. As interest rates rise, the prices of bonds fall. Long-term bonds are more exposed to interest-rate risk than short-term bonds. Although the information in this report has been obtained from sources that the firm believes to be reliable, we do not guarantee its accuracy, and any such information may be incomplete or condensed. All opinions included in the report constitute the authors’ judgment as of the date of this report and are subject to change without notice. This report is for informational purposes only and is not intended as an offer or solicitation with respect to the purchase or sale of any security. Madison Scottsdale is the Insurance Asset Management Division of Madison Investment Advisors, LLC ©August 14, 2017.