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Weighing policy in portfolio construction

| August 21, 2020

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.

A lot of things changed after March both in markets and in the economy. To the long list of changes, add the correlation of asset prices and the impact of policy risk. The value of high-quality assets has become much more loosely linked since March while the value of low-quality assets has become much more tightly linked. It has become surprisingly easier to hold a diversified portfolio of fixed income investments. We almost certainly have the Fed to thank for that.

The correlation of daily asset prices has changed significantly since March, at least compared to markets before coronavirus. In the period between early September last year and mid-January, day-to-day changes in the value of government debt, agency MBS and investment grade corporate debt all had correlations between 0.73 and 0.90 (Exhibit 1). High yield debt and leveraged loans generally had small negative correlations with higher quality assets and a modest 0.37 correlation with each other. Correlations at roughly these levels have held since at least the start of 2018.

Exhibit 1: Fixed income asset correlations have shifted significantly since March

Note: Asset classes represented by indexed ETFs: GOVT for Treasury debt, MBB for MBS, LQD for IG corporates, HYG for high yield and BKLN for leveraged loans. Source: Bloomberg, Amherst Pierpont Securities

After the Fed’s key announcements on March 23 and the enactment of the CARES Act five days later, the landscape shifted. Correlations between government debt, MBS and investment grade corporate debt dropped significantly to between 0.12 and 0.33. High yield and leveraged loans remained negatively correlated to government debt but became positively correlated to MBS and investment grade corporates. And the correlation between high yield and leveraged loans more than doubled to 0.79.

The shifts in asset correlation almost certainly reflects the Fed’s broad effect of lowering the volatility of interest rates. QE and Fed guidance have helped keep rate volatility low since March, reducing the impact of duration on asset price. And falling volatility in the performance of Treasury debt almost inevitably means falling correlation with other assets. In the extreme, an asset with no volatility has a zero correlation with everything.

Instead, spread changes have dominated performance, and spreads have seen clear impact from different Fed programs to buy MBS and corporate debt. These programs have not always operated in synch, however, lowering the correlation between MBS and investment grade corporates. The pairing of Fed purchases in investment grade and high yield corporate debt has raised the correlation between these assets. The higher correlation between high yield and leveraged loans likely reflects the increased sensitivity of both sectors to the path of the economy.

The shift in asset correlation highlights the dimension of policy risk embedded across US and global fixed income. Policy for now has largely neutralized duration and magnified the impact of spreads. But policy does not have an equal impact across asset spreads, making it valuable for portfolios to diversify across assets affected by Fed and other government efforts. Investors should diversify policy risk.

Heading into November, policy risk should have more impact on asset performance. Policy differences between the parties include views of taxes, debt and spending, the direction of Fannie Mae and Freddie Mac and the role of the Consumer Finance Protection Bureau. These could influence performance from Treasury and agency debt to MBS and ABS.

The trade in this market is to increase both spread duration and spread diversification. QE should give a big lift to spread duration. The realized and potential differences in policy should make spread diversification more valuable than usual.

* * *

The view in rates

Despite some recent improvement, the rates market still looks bearish on growth. The 10-year real rate has dipped back below -100 bp while the market holds onto its expectations of inflation with the spread between 10-year notes and TIPS implying inflation of 164 bp. Real rates still could drop further if the Fed this fall shows willingness to let inflation return to target and go higher, all the while holding nominal rates down. After steepening aggressively two weeks ago with 2s10s finishing August 14 at 56 bp, it has dropped by to 49 bp. And 5s30s, which ran up to 115 bp, has dropped to 108 bp. QE should continue biasing the curve to steepen.

The view in spreads

Spread compression continues. As the Fed continues to absorb high quality assets and spreads tighten, investors will have to move to the next tier of higher risk to get sufficient margin. Risk assets remain caught between Fed buying on one hand and heavy net supply of Treasury debt on the other. There is still fundamental risk in the most leveraged corporate balance sheets with corporate leverage going up through 2020, and only there might spreads continue lagging the rest of the market.

As a side effect of the steeper Treasury curve, projected OAS in MBS should rise as should estimated option-adjusted duration. A steeper curve presents prepayment models with rising rates, and will almost the entire MBS market trading at a premium, rising rates mean slower prepayments and better spreads.

The view in credit

Fundamental credit remains as uncertain as the economy, but the downside in leveraged credit outweighs the upside for now. Many investment grade companies have stockpiled enough cash to survive protracted slow growth, but highly leveraged companies and consumers are at risk. Prices on some sectors of leveraged loans, rating agency downgrades in leveraged loans and high yield and rising bank loan loss reserves signal a wave of distressed credit. Elevated unemployment and delinquency rates in assets from MBS to auto loans show pressure on the consumer balance sheet. However, monetary and fiscal policies are both shoring up these fundamentals for now. The course of leveraged corporate and consumer credit also depends on renewal of fiscal support and other programs.

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