Whatever It Takes
The quarter began with continued Federal Reserve (Fed) policy actions to stem the significant decline in economic activity. The key policy regarding the fixed income market was the suspension of supplementary leverage ratios for banks. This was done to ease strains in the Treasury market. During the March sell-off, Treasury yields moved higher and became very illiquid. The Fed has made it clear via their actions and follow-up statements they will act extremely aggressively to alleviate strains in the Treasury market.

Deficits are set to surge in the coming quarters, and when combined with declining foreign ownership of Treasuries, suggests that at the margin longer-term Treasuries yields would face upward pressure. To prevent this, the Fed is debating how to implement yield-curve control. A formal policy is expected before the end of the year. Yield curve control is when they peg interest rates via buying unlimited amounts of bonds to maintain the targeted yield. To maintain a functioning Treasury market, real yields are likely to be negative for a lengthy period. This will only exacerbate the “reach for yield” concept that has driven markets for the last couple of years. The last time this type of policy was implemented was during World War II, which resulted in risk assets outperforming Treasuries by a significant margin.

By the end of the quarter, the Fed had purchased investment-grade corporate bonds and individual domestic corporate bonds. The Fed balance sheet went up by more than $1 trillion during the quarter.

Positioning and Outlook
Looking forward, we anticipate the Fed will implement yield-curve control and do not foresee significant return opportunities from duration management. We would look to target duration in-line with benchmarks over the coming quarter.

With yields at such low levels, corporate bond returns are driven by the change in spreads and this contribution is much higher than historical averages. Thus, if corporate bond spreads continue to tighten, their returns can be well above the starting yield. Of course, spread widening will lead to outsized losses. The total return strategies are slightly overweight corporate bonds, despite expectation for a sell-off in the third quarter. We would use the weakness in spreads to increase exposure on the expectation the Fed and fiscal policy response will be significantly large to prevent a self-sustaining feedback loop of falling asset prices. This should enable corporate bonds to outperform over the next several quarters.

The median corporate bond spread is back to pre-crisis levels; however, the overall index remains wider due to more bonds with spreads well wide of the index. In recent weeks, these wider-spread bonds have started to tighten and have been the winners despite having the weakest balance sheet and growth outlooks. It remains to be seen if the Fed policy support will save the entire investment grade universe or if some of the weaker names will slip through the cracks and face increasing bankruptcy pressure. When these bond spreads tighten, it follows the theory of reflexivity in that investors’ perceptions impact actual fundamentals. Investors and the Fed drive down spreads, which lowers the cost of capital and decreases the probability of default.

Source: BTC Capital Management, Bloomberg LP, Ibbotson Associates, FactSet.
The information provided has been obtained from sources deemed reliable, but BTC Capital Management and its affiliates cannot guarantee accuracy. Past performance is not a guarantee of future returns. Performance over periods exceeding 12 months has been annualized.

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