Uncategorized
Weighing policy in portfolio construction
admin | 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. This material does not constitute research.
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.
This material is intended only for institutional investors and does not carry all of the independence and disclosure standards of retail debt research reports. In the preparation of this material, the author may have consulted or otherwise discussed the matters referenced herein with one or more of SCM’s trading desks, any of which may have accumulated or otherwise taken a position, long or short, in any of the financial instruments discussed in or related to this material. Further, SCM may act as a market maker or principal dealer and may have proprietary interests that differ or conflict with the recipient hereof, in connection with any financial instrument discussed in or related to this material.
This message, including any attachments or links contained herein, is subject to important disclaimers, conditions, and disclosures regarding Electronic Communications, which you can find at https://portfolio-strategy.apsec.com/sancap-disclaimers-and-disclosures.
Important Disclaimers
Copyright © 2024 Santander US Capital Markets LLC and its affiliates (“SCM”). All rights reserved. SCM is a member of FINRA and SIPC. This material is intended for limited distribution to institutions only and is not publicly available. Any unauthorized use or disclosure is prohibited.
In making this material available, SCM (i) is not providing any advice to the recipient, including, without limitation, any advice as to investment, legal, accounting, tax and financial matters, (ii) is not acting as an advisor or fiduciary in respect of the recipient, (iii) is not making any predictions or projections and (iv) intends that any recipient to which SCM has provided this material is an “institutional investor” (as defined under applicable law and regulation, including FINRA Rule 4512 and that this material will not be disseminated, in whole or part, to any third party by the recipient.
The author of this material is an economist, desk strategist or trader. In the preparation of this material, the author may have consulted or otherwise discussed the matters referenced herein with one or more of SCM’s trading desks, any of which may have accumulated or otherwise taken a position, long or short, in any of the financial instruments discussed in or related to this material. Further, SCM or any of its affiliates may act as a market maker or principal dealer and may have proprietary interests that differ or conflict with the recipient hereof, in connection with any financial instrument discussed in or related to this material.
This material (i) has been prepared for information purposes only and does not constitute a solicitation or an offer to buy or sell any securities, related investments or other financial instruments, (ii) is neither research, a “research report” as commonly understood under the securities laws and regulations promulgated thereunder nor the product of a research department, (iii) or parts thereof may have been obtained from various sources, the reliability of which has not been verified and cannot be guaranteed by SCM, (iv) should not be reproduced or disclosed to any other person, without SCM’s prior consent and (v) is not intended for distribution in any jurisdiction in which its distribution would be prohibited.
In connection with this material, SCM (i) makes no representation or warranties as to the appropriateness or reliance for use in any transaction or as to the permissibility or legality of any financial instrument in any jurisdiction, (ii) believes the information in this material to be reliable, has not independently verified such information and makes no representation, express or implied, with regard to the accuracy or completeness of such information, (iii) accepts no responsibility or liability as to any reliance placed, or investment decision made, on the basis of such information by the recipient and (iv) does not undertake, and disclaims any duty to undertake, to update or to revise the information contained in this material.
Unless otherwise stated, the views, opinions, forecasts, valuations, or estimates contained in this material are those solely of the author, as of the date of publication of this material, and are subject to change without notice. The recipient of this material should make an independent evaluation of this information and make such other investigations as the recipient considers necessary (including obtaining independent financial advice), before transacting in any financial market or instrument discussed in or related to this material.
Important disclaimers for clients in the EU and UK
This publication has been prepared by Trading Desk Strategists within the Sales and Trading functions of Santander US Capital Markets LLC (“SanCap”), the US registered broker-dealer of Santander Corporate & Investment Banking. This communication is distributed in the EEA by Banco Santander S.A., a credit institution registered in Spain and authorised and regulated by the Bank of Spain and the CNMV. Any EEA recipient of this communication that would like to affect any transaction in any security or issuer discussed herein should do so with Banco Santander S.A. or any of its affiliates (together “Santander”). This communication has been distributed in the UK by Banco Santander, S.A.’s London branch, authorised by the Bank of Spain and subject to regulatory oversight on certain matters by the Financial Conduct Authority (FCA) and the Prudential Regulation Authority (PRA).
The publication is intended for exclusive use for Professional Clients and Eligible Counterparties as defined by MiFID II and is not intended for use by retail customers or for any persons or entities in any jurisdictions or country where such distribution or use would be contrary to local law or regulation.
This material is not a product of Santander´s Research Team and does not constitute independent investment research. This is a marketing communication and may contain ¨investment recommendations¨ as defined by the Market Abuse Regulation 596/2014 ("MAR"). This publication has not been prepared in accordance with legal requirements designed to promote the independence of research and is not subject to any prohibition on dealing ahead of the dissemination of investment research. The author, date and time of the production of this publication are as indicated herein.
This publication does not constitute investment advice and may not be relied upon to form an investment decision, nor should it be construed as any offer to sell or issue or invitation to purchase, acquire or subscribe for any instruments referred herein. The publication has been prepared in good faith and based on information Santander considers reliable as of the date of publication, but Santander does not guarantee or represent, express or implied, that such information is accurate or complete. All estimates, forecasts and opinions are current as at the date of this publication and are subject to change without notice. Unless otherwise indicated, Santander does not intend to update this publication. The views and commentary in this publication may not be objective or independent of the interests of the Trading and Sales functions of Santander, who may be active participants in the markets, investments or strategies referred to herein and/or may receive compensation from investment banking and non-investment banking services from entities mentioned herein. Santander may trade as principal, make a market or hold positions in instruments (or related derivatives) and/or hold financial interest in entities discussed herein. Santander may provide market commentary or trading strategies to other clients or engage in transactions which may differ from views expressed herein. Santander may have acted upon the contents of this publication prior to you having received it.
This publication is intended for the exclusive use of the recipient and must not be reproduced, redistributed or transmitted, in whole or in part, without Santander’s consent. The recipient agrees to keep confidential at all times information contained herein.
