Holding fast to longer-term convictions amid short-term market dislocations can be discomfiting, but also creates opportunities for active bond managers.
Bond Market Disruptions: When Risk Means Opportunity
The inversion in the yield curve for U.S. Treasuries in March reflected investor concerns about short-term rates. But those worries proved transient – making it possible for bond investors unswayed by disruption to ulitmately profit from them.
Holding fast to a well-grounded market thesis amid short-term concerns is, of course, a common theme in bond investing. Consider the European sovereign debt crisis of 2011-12. Economic conditions in Europe deteriorated just as the European Central Bank (ECB) was winding down its stimulative actions taken at the end of the 2008-9 global financial crisis. The result was a rapid rise in yields for both sovereign debt and European corporate bonds – a classic case of indiscriminate selling. There was relatively little backwash into U.S. credit markets at the time, resulting in a spread of some 500 basis points (bps) between European high-yield corporates and similar credits in the U.S. That spread then reverted to its 100-basis point mean over the following two years after the ECB forthrightly reversed course – to the benefit of fixed-income investors who recognized the opportunity, including Brandywine Global, only one example of a curve showing the way to an opportunity as well as a risk.
Reversion to the Mean as Potential Investment Opportunity
Chart courtesy of Brandywine Global. Sources: Bank of America Merrill Lynch / Bloomberg, as of 3/28/2019. Past performance is no guarantee of future results. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.
On the rise: Mid-range U.S. Treasury yields
Over the past week, the 2-, 3-, 5- and 7-year Treasuries moved up roughly 6.5 and 10 bps, leaving the U.S. Treasury yield curve noticeably less inverted than in previous weeks. Only the 3-month/5-year Treasury spread remains inverted, and that only by -1.85 bps. The closely-watched 3-month/10-year spread is now about 16.7 bps, above zero since the end of March.1
But these moves shouldn't be read as an end of the need to watch the economy carefully. One interpretation of the rise in these shorter-term yields is as a consequence of the increased issuance of shorter-dated Treasuries as the federal government's appetite for debt – and need for additional funds – grows. The increased debt burden that this supply represents is viewed by some as a drag on future economic growth. But the rise can also be seen as an indirect result of the back-from-the-brink negotiations between China and the U.S. over trade.
On the slide: The Brazilian Real
Brazil's currency fell a bit more than -2% vs. the dollar over the past week, making it the second-worst of the high-profile currencies for the period – better than only the 2.06% fall in Colombia's peso, driven by pressures from refugees fleeing Venezuela’s economic chaos.
President Jair Balsonaro has been largely unable to generate economic goodwill during his recent trip to the U.S., during which his joint press conference with President Donald Trump was treated indifferently by financial markets.
More significantly, Brazil's economic activity, as measured by the country's central bank, fell -0.73% in February from January, following a downwardly-revised 0.31% fall in January. This news doesn't augur well for President Balsonaro's high-profile plans to reform the country's pension system, or to pull the country away from the brink of yet another recession.
All data Source: Bloomberg as of April 16, 2019 unless otherwise specified.
1 Source: Bloomberg, April 16, 2019, 5:00 PM ET
An Inverted yield curve is a market condition in which yields for longer-maturity bonds have yields which are lower than shorter-maturity issues.
A spread is the difference in yield between two different types of fixed income securities with similar maturities; usually between a Treasury or sovereign security and a non-Treasury or non-sovereign security.
A credit spread is the difference in yield between two different types of fixed income securities with similar maturities, where the spread is due to a difference in creditworthiness or credit rating.
An option-adjusted spread (OAS) is a measure of risk that shows credit spreads with adjustments made to neutralize the impact of embedded options.
A basis point is one one-hundredth (1/100, or 0.01) of one percentage point.