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AAM Viewpoints – What a Month! The Fixed Income Takeaway to Take Away


“Know what you own and know why you own it.” – Peter Lynch


What a difference a month makes! Investors will look back on 2018 and likely remember the year as defined by events of the last quarter, and most especially the last 30 days. Concerns over the prospects for global growth caught the attention of fixed income and equity investors alike in Q4 (4th quarter) 2018 and swift sentiment shifts brought sharp reversals across financial markets. Equity investors suffered through one of the worst quarters since The Great Recession with S&P 500 down -13.52% on a total return basis. The month of December 2018 was especially rough with the S&P 500 down -9.03% on a total return basis. Fixed income indices across the board were flat or in the red entering December as markets fought headwinds associated with higher rates across the year. 2018 brought cyclical highs on the 2-year U.S. Treasury and the 10-year rate touched levels last seen in 2011. As late into the year as November 30, U.S. Treasuries (BBG Barclays U.S. Treasury Index) were down -1.27% year-to-date and heading for only the fourth down year in the last 20. Municipals (BBG Barclays Municipal Index +0.08%) and High Yield (BBG Barclays US High Yield Index +0.06%) were the only major asset classes in the black, hanging on by a thread and, and for all intents and purposes flat on the year. By year end, after a sharp sell-off in credit and interest rates lower across the board, Municipals were left as the best performing U.S. fixed income asset class on the year up +1.28%, High Yield was off to the tune of -2.08% and U.S. Treasuries staged a rally to end the year back in positive territory at 0.86%.


If you are dizzy you are not alone. The year-end reversal in sentiment has left investors facing the conundrum of staying the course or reallocating in anticipation of more volatility. Did the events of December 2018 represent an inflection point in the economic cycle or a correction against an otherwise healthy backdrop? This question is especially pertinent to fixed income investors as the answer likely dictates asset allocations moving forward. While the environment for fixed income certainly has some added complexities in 2019, we would view recent events within the context of a healthy correction to alleviate stretched valuations as opposed to any fundamental shift in the economic cycle. Either way, the events that transpired in December should catch your attention. Regardless of your view on the current economic backdrop, we believe that recent volatility should spur action to review and understand your fixed income allocations to insure they reflect your view moving forward.


If there is a single take-away from the recent volatility in fixed income markets it is “Know What You Own!” It never ceases to amaze that many investors and advisors carry a broad notion that a bond is a bond is a bond. This could not be further from the truth. Look no further than recent performance in fixed income markets to see this theme at work. Up until the start of December, High Yield markets were having a decent year and were the best performing asset class in U.S. fixed income markets. By the end of December, High Yield was experiencing a sharp sell-off with credit spreads widening off cycle lows and the equity markets faltering. This should come as no surprise. High Yield markets are sensitive to the same economic factors that drive equity markets. Many times, especially during periods of volatility, High Yield is more sensitive to economic factors via credit spreads than interest rates. This is also the reason that the asset class can and does swing to a positive correlation with equity markets during times of stress.


Contrast that with the U.S. Treasury market which is considered “riskless,” includes no compensation for credit risk and is considered the “safest” fixed income investment in the world. U.S. Treasuries, until Q4 2018, were one of the worst-performing fixed income asset classes across 2018 because the asset class tends to be the most sensitive to interest rates and rates were up broadly across the year. With concerns over the prospects for slowing growth, rates fell sharply in December and investors clamored into Treasuries with a strong risk-off, flight to quality trade and U.S. Treasuries ended the month as one of the best-performing U.S. fixed income asset classes.


The important takeaway for fixed income investors should be a recognition that all bonds are subject to interest rate risk, credit risk or some combination of the two. It is critical to understand how these exposures behave in differing environments. While High Yield bonds generally carry more credit risk than their Investment Grade counterparts, the imaginary line the market draws at BBB-/Baa3 rated bonds to separate High Yield and Investment Grade can be a poor representation of where these exposures lie. Ratings agencies are also not necessarily the best representation of the interest rate risk and credit risk combination for many areas in the fixed income markets. Unfortunately, as you approach the BBB area of any fixed income market, whether taxable or tax-exempt, the exact combination of interest and credit risk becomes the murkiest. In addition, many investors have been pushed to the margins over the last 10 years. Investors may have introduced more risk in a search for yield, in what has been an underwhelming yield environment, or like many, they may not recognize that changing market dynamics could have pushed them to the margins. The era of easy money and low interest rates has pushed up leverage levels of corporate issuers over this expansion. On the back of healthy earnings free cash flows have risen faster than leverage but it has brought fundamental changes to the investment grade landscape as approximately 50% of all investment grade debt now resides in BBB rated territory. This brings with it changes to the interest rate risk/credit risk mix and any investment in broad Investment Grade funds and/or ETFs (exchange-traded funds) likely includes an unavoidable exposure to more credit risk than in cycles past.


Whether you are a more risk tolerant investor looking to take advantage of recent dislocations in the High Yield markets or an investor with a stance of capital preservation looking to reduce overall volatility and increase credit risk, it starts with a basic understanding of what you own and what fundamental economic factors drive returns. AAM offers financial advisors a variety of avenues to review their book of business whether it is existing or proposed fixed income allocations. We have team of financial professionals who can assist, consult and guide on almost all aspects of your portfolio. If you are unsure if your fixed income allocations are working for you, know we are a phone call away.


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.


2019-0110-7152 R


 


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