Total Return Outlook Second Quarter 2023

By: Eddy Vataru, John Sheehan and Daniel Oh

A New Type of Dual Mandate

The investment grade fixed income market enjoyed a strong, yet volatile, start to the year. The Bloomberg Aggregate Index (Agg) bounced back nicely following 2022’s unprecedented 13% loss, its worst-ever performance for a full calendar year. The Agg returned 2.96% in the first quarter of 2023, as investors directed meaningful flows to investment grade bonds, partially to participate in their recovery and also to benefit from the potential of a Fed pivot (either ending or perhaps even reversing its restrictive monetary policy).

The Federal Reserve was faced with a new form of a dual mandate in the first quarter, as two bank failures forced it to provide sufficient liquidity to the banking sector while maintaining vigilance in its fight against inflation (as if manufacturing a soft landing was not already difficult enough). A modern-day point-and-click run on Silicon Valley Bank culminated in the second largest bank failure in history when California regulators seized control of the $200 billion bank on March 10th. Two days later, New York regulators took similar action on Signature Bank, which heightened concerns around a systemic banking collapse. The contagion was not limited to U.S. shores, as Credit Suisse was forced into a fire-sale merger with UBS by the Swiss National Bank. Not surprisingly, investors responded to the crack in the confidence of the banking system by seeking safe-haven investments.

The resulting flight-to-quality led to a rally in the two-year note of over 125 basis points (bps), and the fed funds futures markets went from pricing 99 bps of hikes to 89 bps of cuts by December of this year. The primary instrument to measure volatility in the fixed income market, ICE BofA MOVE index, fell just short of hitting 200, which is a level not seen since the depths of the Great Financial Crisis in October 2008. To stem the tide, the Federal Reserve, the FDIC, and the United States Department of Treasury issued a joint statement in support of the banking system and honored the deposits of Silicon Valley Bank and Signature Bank. The Federal Reserve also announced the creation of the Bank Term Funding Program (BTFP), which provides liquidity to other depository institutions to prevent further bank runs. The BTFP allows eligible depository institutions to borrow against their long-dated U.S. Treasuries and agency mortgage-backed securities (MBS) at par, even if the securities are trading at a discount in the open market.

In perhaps the most highly anticipated and debated recent Fed meeting, which is saying a lot, the Federal Open Market Committee (FOMC) increased rates by 25 bps to 4.75-5.00%. The FOMC commented that the “The U.S. banking system is sound and resilient” but also acknowledged that the recent developments are likely to tighten financial conditions. Chairman Powell was successful in shifting the narrative from a soft landing to fighting inflation and a liquidity crisis. While the Fed may have been successful in averting a liquidity run, we are reminded how quickly the market reacts to the slightest whiff of Fed easing. The newly launched BTFP program has quickly been designated “Buy the ___ Pivot.”

Looking forward, we remain constructive on duration and will continue to invest in longer-dated assets. While we do not envy the task of the Federal Reserve, our preferred measure of persistent inflation, the Underlying Inflation Gauge, confirms an undeniable trend of lower inflation. This quarter’s reading showed a consistent monthly decline of ~30-40 bps and a drop from the peak of last summer of over 150 bps. We acknowledge that the path to lower inflation will not be a straight line and will likely become sticky before reaching the Fed’s 2% target. However, with long rates near 4%, the risks are skewed in favor of the Fed being successful. Lastly, as we saw this quarter with the bank failures, a long duration position is the primary beneficiary of the unknown.

Our preferred expression of a long duration position has begun to migrate from U.S. Treasuries to agency mortgage-backed securities (MBS). Given the uncertainty of the macroeconomic environment, we remain committed to keeping the credit quality of the portfolio high, and U.S. agency MBS are consistent with that view. The extreme volatility of interest rates in the first quarter caused MBS spreads to widen substantially and eclipse option-adjusted investment grade corporate spreads. (For more information, please read our latest commentary about how we find relative value in the investment grade market.) We believe that MBS spreads will tighten going forward as interest rate volatility recedes. Additionally, we are attracted to pockets of the asset backed securitization (ABS) market that offer attractive risk-adjusted returns. Specifically, aircraft finance and litigation finance are sectors that we feel will benefit from continued recovery and adoption.

Investment grade corporates remain a sector caught in the crosscurrents of Fed policy and a softening economy. The option-adjusted spread of the Agg ended the quarter at 138 bps and traded in a 50 bp range this quarter (from 115 bps to 165 bps). As we look forward, we think Fed policy, rather than the threat of recession, will have a greater influence on spreads, but we will look for better valuation before meaningfully reversing our historically low allocation to corporates.

To paraphrase a famous quote, there are decades where nothing happens and there are quarters where decades happen. We certainly feel that the market experienced a decade worth of market-moving events this quarter. We are appreciative of your continued support and will continue to seek superior risk-adjusted returns on your behalf.

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Originally Posted April 18, 2023 – A New Type of Dual Mandate: Total Return Outlook Second Quarter 2023

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The Bloomberg U.S. Aggregate Bond Index (Agg) is widely regarded as the standard for measuring U.S. investment grade bond market performance.

Source for any Bloomberg index is Bloomberg Index Services Limited. BLOOMBERG® is a trademark and service mark of Bloomberg Finance L.P. and its affiliates (collectively “Bloomberg”). Bloomberg owns all proprietary rights in the Bloomberg Indices. Bloomberg does not approve or endorse this material, or guarantees the accuracy or completeness of any information herein, or makes any warranty, express or implied, as to the results to be obtained therefrom and, to the maximum extent allowed by law, neither shall have any liability or responsibility for injury or damages arising in connection therewith.

The fed funds rate is the rate at which depository institutions (banks) lend their reserve balances to other banks on an overnight basis.

A basis point is a unit that is equal to 1/100th of 1%.

The Underlying Inflation Gauge (UIG) captures sustained movements in inflation from information contained in a broad set of price, real activity, and financial data.

Investment grade bonds are those with high and medium credit quality as determined by ratings agencies.

Duration measures the sensitivity of a fixed income security’s price to changes in interest rates. Fixed income securities with longer durations generally have more volatile prices than those of comparable quality with shorter durations.

Treasuries are securities sold by the federal government to consumers and investors to fund its operations. They are all backed by “the full faith and credit of the United States government” and thus are considered free of default risk.

A mortgage-backed security (MBS) is a type of asset-backed security that is secured by a mortgage or collection of mortgages.

An asset-backed security (ABS) is a type of financial investment that is collateralized by an underlying pool of assets—usually ones that generate a cash flow from debt, such as loans, leases, credit card balances, or receivables.

Merrill Lynch Option Volatility Estimate (MOVE) Index – U.S.D – is a yield curve weighted index of the normalized implied volatility on 1-month Treasury options.

Spread is the difference in yield between a risk-free asset such as a Treasury bond and another security with the same maturity but of lesser quality. Option-Adjusted Spread is a spread calculation for securities with embedded options and takes into account that expected cash flows will fluctuate as interest rates change.

Osterweis Capital Management is the adviser to the Osterweis Funds, which are distributed by Quasar Distributors, LLC. [OSTE-20230410-0831]