Total return approach, investing across full spectrum of the fixed income market including up to 20% in below investment-grade securities.
Dynamic Core Bond Strategy
- Rates rose and bonds prices declined as the US Federal Reserve maintained a decidedly hawkish tone and inflation reports underscored the US central bank still has work to do.
- The Strategy outperformed its benchmark, the Bloomberg U.S. Aggregate Bond Index (the Index) on a net asset value (NAV) basis, with sector allocation, security selection and duration and yield curve decisions all contributing.
- Growth is slowing, with higher rates and persistent inflation cooling segments of the economy. These challenges are unlikely to cause a deep recession and the rise in nominal yields across sectors will present tactical opportunities.
For the quarter ended September 30, 2022, the Strategy outperformed the Index on NAV basis. Sector allocation contributed the most to performance. Meanwhile, security selection and duration and yield curve positioning also contributed.
The unusual environment of slower growth, high inflation and a tight labor market continued to drive market volatility in the third quarter of 2022. Recent tightening by the Fed has had a clear impact on interest rate sensitive parts of the economy such as housing but has not had the desired effect of cooling the labor market and wages. The additional 75 basis points (bp) rate hike delivered by the Fed at their July meeting was fully expected by markets, however Powell’s comments after the meeting, which were perceived to be on the dovish side, sent yields lower. Speculation of a Fed “pivot” began to grow, and as a result, financial conditions began to ease, fueling a rally in risk assets. This dynamic came to a swift and decisive end following Powell’s speech at Jackson Hole in which he declared the economy would feel “some pain” as the Fed will need hold a restrictive stance for an extended period of time. Further fueling the resumed selloff was a hotter than expected consumer price Index (CPI) reading, which reset the clock for a potential pause in rate hikes, as well as a surprise uptick in the number of job openings. By September, another 75 bp rate hike was fully expected by markets, and the Fed delivered on those expectations while also reiterating their intentions of “higher for longer”. After dropping close to 2.50% intra-quarter, the 10-year Treasury closed the quarter around 80 bp higher at 3.83%. The selloff in the 2-year was even more dramatic, leading to a further inversion of the yield curve.
Positive correlation between rates and spreads continued through 3Q22, however spreads finished the quarter roughly where they started. The see-saw in interest rates contributed to spread sectors performing in a similar fashion. High yield (HY) corporate bonds proved to be an exception to rule as the sector posted positive nominal and excess returns for the quarter. Meanwhile, the agency mortgage-backed securities (MBS) market was rattled by ongoing rate volatility resulting in that sector posting the worst relative performance for the quarter.
A more defensive posture with a bias towards liquidity and tactical shifts supported outperformance. Outperformance benefited from duration positioning that included a modest overweight early in the period as rates initially declined after the Fed’s July meeting. Within sector allocations, the Strategy benefited the most from our HY corporate exposures, as this sector bucked the trend and posted positive performance for the period. We shifted investment grade (IG) corporate allocations, selling into strength early in period and then redeploying capital in this sector in September as nominal yields and spreads offered opportunities. Across securitized, our agency MBS overweight was a small detractor as rate volatility proved a significant hurdle to the sector. Meanwhile, asset-backed securities (ABS) sector allocations added given the lower beta characteristics of this sector. In security selection, agency MBS selection that included collateralized mortgage obligations (CMOs) added to performance, while ABS security selection that included high quality collateralized loan obligations (CLOs) detracted. Lastly emerging market (EM) security selection was also positive across sovereign and corporate hard currency markets.
Current Strategy and Outlook
Higher prices have taken a significant bite out of household income, and as a result, consumer spending on an inflation adjusted basis has stagnated. We expect this trend to continue, with further monetary tightening resulting in additional demand destruction that will lead to an environment of weak global growth and US growth below trend if not negative. We do not however, expect a deep recession. This is because, while inflation has created a challenge for spending growth, the strong financial position of households, having recently de-levered in the early days of the pandemic, grants consumers the ability to maintain spending levels, with job security created by the excess demand for labor supporting their willingness to spend.
With a background of weaker global growth, we expect inflation to slowly decline in the months ahead, while the shelter component will keep inflation above the Fed’s comfort zone well into 2023. As a result, the Fed will push further into restrictive territory until inflation is clearly moving toward their target and will resist the urge to ease as long as the labor market remains strong.
With a difficult, and narrow path to a soft landing, the portfolio remains in a relatively defensive posture. With liquidity challenged, we have used liquid instruments to both hedge risk and take advantage of tactical market opportunities presented by the elevated level of volatility.