Bonds Commentary
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Clipping Coupons As Price Gains Harder To Come By

July 2020

June was, broadly speaking, a non-event month in fixed income land. Treasury yields remained range-bound, particularly on the short-end of the yield curve. The 2-year U.S. Treasury yield was unchanged month over month at 0.16%, while the 10-year yield, after attempting to break out above 0.90% very early in June, ended the month at 0.66%, just one basis point above its May 29 close. The 50-basis point spread between the 2-year and 10-year is worth monitoring and at a minimum needs to be maintained in our view as this is a level that has been defended on numerous occasions and a sustained break below might signal a shift in expectations and more dire outlook for inflation and economic growth. Conversely, should the spread widen due to a higher 10-year yield, not a lower 2-year yield, this would be a positive indication that economic growth and/or inflation expectations are firming.

Investment-grade (IG) corporate bonds continued to perform well in June, backstopped by Fed and Treasury purchases of IG and fallen angel ETFs, a program expanded last month to include purchases of individual corporate issues. The Bloomberg Barclays U.S. Corporate index was higher by 5% year-to-date through June and carried a yield-to-worst of 2.15% at month-end, 0.65% above the benchmark 10-year U.S. Treasury yield. The option adjusted spread (OAS), or yield compensation for taking on credit risk, for the index over the 10-year U.S. Treasury sat at just 1.50% at the end of June, just below the index’s 20-year average OAS. The Fed and Treasury created a rising tide lifts all ships backdrop in late March with the announcement of the creation of the Secondary Market Corporate Credit Facility (SMCCF), but as noted above, the program was expanded in June to include purchases of individual corporate bonds. Through buying individual corporate issues while shunning bonds from other investment-grade issuers as it constructs its own ‘index,’ the Fed risks creating a dual-class structure of sorts among IG issuers. While index-linked exposure to IG corporates has worked well up to this point, security selection and active management should play a larger role as performance dispersion at the issuer level increases.

Despite low yields relative to historical norms, IG corporates continue to hold some appeal as the SMCCF remains in place, allowing market participants to buy these bonds with the knowledge that they will find a buyer with deep pockets willing to take it off their hands, likely at a higher price, should they choose to sell. High yield corporates, as expected, have been more sensitive to economic ebbs and flows over the past month, with the Bloomberg Barclays Corporate High Yield index generating a 1% total return during June, the bulk of which was the result of interest payments, i.e. clipping coupons, not price improvement, as the YTW on the index fell from 7.02% on May 29 to 6.87% at month-end. High yield corporates traded at a spread of 626 basis points, or 6.26%, over the 10-year U.S. Treasury yield at month-end, versus a 20-year average OAS of 5.50%. While high yield bonds don’t appear cheap on an absolute basis given the uncertain economic backdrop and its potential impacts on commodities, specifically, these bonds appear more attractive on a relative basis versus the index’s own history and when compared to Treasuries and IG corporates. We maintain a neutral exposure to high yield bonds relative to our strategic long-term target as the yield pickup, or carry, remains too good to give up by allocating proceeds elsewhere, even as we anticipate an uptick in defaults from here through year-end.

Source: Bloomberg, Factset

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