Fixed income returns for the quarter were positive as corporate bonds excelled. Shorter duration Treasuries remain glued to the floor on the expectation it will be several years before the Federal Open Market Committee attempts to raise the federal funds rate. Longer duration yields moved higher in the quarter with the 10-year Treasury rising from 0.68% to 0.91%. Despite the rise in yields, fixed income returns were up as corporate bond spreads tightened significantly. BBB-rated and longer-duration corporate bonds performed the best.
Once again fixed income returns blew away dire predictions forecasted at the beginning of the calendar year. The Barclays Aggregate Bond Index began the year with a yield of 2.31% and forecasts of negative returns. It ended the year with a yield of 1.12%, a total return of 7.51%, and another consecutive year of forecasted losses for 2021. Not only did the broad index generate solid returns, but there were several areas of the fixed income market that excelled with little fanfare. Long duration corporate bonds posted gains of 13.9%, while long duration Treasuries continue to be the gold standard. They posted a 17.7% gain in 2020 and have a 40-year compounded annual gain of 9.5%, which is greater than the Russell 1000 Value Index over the same time span.
Positioning and Outlook
A common misconception is as the yields fall, return expectations should not only fall, but become more predictable. This holds true for shorter-duration securities, but not for longer-duration bonds. This is due to the bond’s price being significantly impacted by small changes in interest rates. Most fail to appreciate how powerful this can be. An example in recent years was the Austrian 100-year government bond yield going from 1.85% to 0.61% and the price going up 73% in less than a year. The United States has a maximum maturity of 30 years on their government bonds, but you can see the implication if yields move 50-75 basis points over the course of the year. And now, corporate bond spreads comprise a much higher percentage of the yield, thereby setting the stage for extremely wide probable outcomes when it comes to longer duration bonds.
Risk assets have reached frothy levels in recent weeks, where surprises to the downside offer the better risk reward. Nearly all the potential risk events have passed, which is precisely the time when markets tend to fall under their own weight as those waiting for the event to pass have finally all bought in. In this scenario, corporate bonds would likely underperform Treasuries. We anticipate an unpredictable 2021 in fixed income with the path diverging wildly from consensus viewpoint of a stable and steady year. We also anticipate reducing our overweight to corporate bonds in early January, as spreads do not appear to be pricing the news narrative turning less optimistic. We remain slightly underweight duration as yields have an upside post the Georgia election, but are open minded to the possibility of lower rates. There are very few asset classes that offer protection when risk assets decline, and Treasuries continue to have this scarcity value.
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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