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Financial Industry Insights from Advisors Asset Management
On January 17, 2017
AAM Viewpoints - A Look Back at 2016 Fixed Income Performance
2016 was a tale of two very different markets. The first six months of 2016 generated positive returns across fixed income asset classes, with the exception of energy and commodity-related credits. The second half was dramatically different after the Brexit vote in July as the U.S. 10-year Treasury yield hit a historical low of 1.36%. Fixed income assets then began trending lower until the U.S. Presidential Election kicked off the sharpest selloff in fixed income assets since 2013.
The most commonly referenced fixed income index, the Bloomberg Barclays U.S. Aggregate Index, posted a loss of -2.98% in the 4th quarter. This was the largest quarterly loss for the index since the 3rd quarter of 1981 and the 5th worst quarter since inception in 1976. The loss also exceeded the 2nd quarter of 2013 during the “Taper Tantrum” which posted a -2.32% loss. As you can see below, almost every asset class was down in the 4th quarter which led investors to reduce fixed income exposure in November and December. The Investment Company Institute (ICI) estimates investors pulled $14.6 billion from Bond ETFs (Exchange-Traded Funds) and Mutual Funds in the last two months of 2016. The majority of those assets came from Municipal ETFS and Mutual Funds which contributed to the volatility in the Municipal market. As you may recall, November marked one of the worst performing months for Municipals in history: the 5-year Municipal lost -2.68% and the 7-year dropped -3.68%, both record-breaking losses for a single month. The 10-year Municipal lost about -4.5%, but no records were broken.
Source: AAM – Bloomberg Barclays Live. Past performance is not indicative of future results.
The table above reflects five consecutive months of negative performance in the Treasury component of the Index. During this period of weakness (lower prices = higher yields) a 10-year trend of lower yields appears to have been broken. The 10-year U.S. Treasury yield has been moving lower since peaking at 5.29% in 2007. It is also important to note that since 2006, the 10-year Treasury yield has finished the year higher than it began only three times. In 2013 the yield was up 127bps (basis points), in 2015 it was up 10bps and in 2016 the 10-year U.S. Treasury yield was up 17bps. The chart below illustrates the movement in yield.
Source: U.S. Department of the Treasury
Although the velocity of the move in Treasuries in November was surprising, conditions in the United States and abroad supported higher rates leading up to U.S. election. After posting sub-par U.S. GDP results through the first half of 2016, conditions improved both domestically and globally during the second half of the year. Improving growth expectations along with healthy labor markets in the United States, improving global growth expectations, improving manufacturing data and falling recessionary odds in developed and developing markets all pointed to higher rates by year end. With the removal of election-related uncertainty along with the prospects of fiscal stimulus, in the form of lower taxes, less regulation and more government spending, equity markets rallied strongly and rates ended the year with the largest increase since the “Taper Tantrum” in 2013 culminating in a FOMC (Federal Open Market Committee) hike in December. Unlike the “Taper Tantrum” in 2013, sparked by Federal Reserve intentions to taper quantitative easing (QE) programs, the sharp increase in rates to end 2016 was supported by improving fundamentals and stronger equity markets likely portending more rate hikes and higher interest rates through the balance of 2017.
As we move into 2017, we continue to position fixed income portfolios defensively for higher rates. Interest rate risk and the sensitivity of the portfolio and individual holdings to increases in the prevailing level of interest rates is of paramount concern for us in the current environment. While no bond is immune to higher rates, we are currently structuring portfolios with an eye toward future rate increases in a context of trying to maximize return. We look to allocate to higher coupon, higher cash flow structures which can be less sensitive to interest rates than their smaller coupon counterparts and also have the potential to provide higher current cash flows for reinvestment. In addition, we look to allocate some monies to callable structures which also can be less sensitive to interest rates than comparable non-call structures. We believe the call risk in these structures is minimal as a called bond over medium term could provide a potential opportunity to reinvest at higher rates. Finally, at this time we prefer informed exposure to credit risk, within the constraints of risk tolerance, in lieu of exposure to more interest rate sensitive holdings.
CRN: 2017-0117-5743 R
This commentary is for informational purposes only. All investments are subject to risk and past performance is no guarantee of future results. Please see the Disclosures webpage for additional risk information at commentary-disclosures. For additional commentary or financial resources, please visit www.aamlive.com.
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