It has become clear over the last decade that global central banks dislike uncertainty. Therefore, and unsurprisingly, most of their policies have sought to suppress asset price volatility to maintain functioning markets. This pattern continued in 2020 through the third quarter. Central banks’ response to the COVID-led market sell-off in March incorporated many of the tools and playbook methods learned after the Great Financial Crisis. In 2020, the Federal Reserve expanded the scope and capacity of these tools.
The pattern remains the same. A large, unexpected, exogenous shock drove a sizeable sell-off in risk assets that is subsequently reversed upon the central banks’ response. The significant difference between 2020 and the reaction function in 2009 is the speed of response and the scale of support.
In the third quarter, fixed income markets continued the rebound that began in the second quarter, with most domestic bond sectors posting positive performance in the three months through September. The recovery in the bond and equity markets has been awe-inspiring. Nearly every fixed income index sits in positive territory for the year with some areas, such as BB-rated high yield, posting double-digit returns, despite still-high unemployment and diminished consumer spending. Meanwhile, the 10-year U.S. Treasury yield has been mostly range-bound between 0.50% and 0.80% since early April.
The Fed has not proven all-powerful, however, and during the quarter unveiled a new policy framework, a central feature of which is a new “average” inflation target of 2%. As the Fed has significantly undershot its 2% target for many years, the implication is that it will allow inflation to overshoot its 2% goal for some period of time. Effectively, the Fed will be operating as if it had a temporarily higher inflation target. How effective policymakers are at engineering inflation depends on many interconnected variables, not the least of which remains the path of COVID-19 and the lingering effects of continued economic lockdowns.
Some good macroeconomic factors did register in July and were followed in August by declining virus infection rates. But in September, amid more mixed economic data, infections resumed their climb and tech stocks led a sell-off in equities. Credit markets broadly shrugged off the market volatility, notwithstanding the final two weeks of the quarter. Hopes Congress and the White House would come to terms on another fiscal stimulus package before the election have faded amid competing issues, mainly tightening election polling and timing on the replacement of late Justice Ruth Bader Ginsburg on the U.S. Supreme Court. Potential for market volatility and economic stress remains elevated.
Third-Quarter 2020 Performance Highlights
- The Thornburg Strategic Income Fund (I shares) returned 3.17% during the third quarter, significantly outperforming the Bloomberg Barclays U.S. Universal Index, which returned 0.99%. As of September 30, 2020, Morningstar ranked the fund in the top quartile versus its peers on a year-to-date, one-year, three-year, five-year and 10-year basis among 339, 330, 292, 248 and 133 Multisector Bond funds, respectively, based on total returns without sales charge.
- During the quarter, we pared back credit risk exposures in the portfolio. Two themes can be seen in our activities; selling names with poor convexity (limited upside) and trimming names, sectors and qualities with elevated downside risks. Some chips have been taken off the table, preparing for potential market jitters, whether related to extended COVID-19 waves, earnings fears or election blues. We have not in wholesale fashion lowered risk in the portfolio, however our bias is to reduce risks, take profits and add to dry powder ahead of potential volatility.
- Our exposure in corporate bonds was reduced from approximately 50% of total portfolio exposure to approximately 44% as spreads continued to grind tighter. About three percentage points of this reduction came from our positions in BB-rated credit. Our exposures in mortgage pass-through securities increased from roughly 1% of the portfolio to nearly 3%. Over the quarter, our portfolio benefited from the strong backdrop related to all things credit, whether asset-backed (ABS), corporate or housing related.
Current Positioning and Outlook
Strong search for yield combined with robust growth relative to dire expectations in the first quarter, and subsiding near-term default risk will continue to incentivize investors to move further into risky territory per the Fed’s design. However, risks over the horizon remain elevated as we move into the last quarter of a dismal 2020 in terms of public health and economic conditions, if not credit market returns.
For example, while unemployment has moved from 3.5% pre-COVID to 14.7% in April and back down to 7.9% at the end of last month, the path for further improvement will be much more difficult. In terms of a fiscal package in front of elections—why would anyone expect an agreement to be announced before the 11th hour, as both sides have to show they are tough and fighting for their values? When, how and how much remain essential components shrouded in uncertainty. Going forward, the likeliest path out of the current COVID-induced economic malaise depends on a working vaccine; yet, even after its development, we will need it to become both widely available and trusted. Current economic facts may appear bleak in certain areas, but there are always opportunities for astute managers.
Investment grade corporate bond issuance reached $168 billion in September and totaled $380 billion in the third quarter and $1.63 trillion yearto- date, up 64% year-on-year and marking new records for the month, the quarter and the year, respectively. Within high yield, the $48 billion priced in September brought year-to-date high-yield issuance to an all-time record of $336 billion and third-quarter issuance to $124 billion, which marked the second-highest quarterly amount on record.
Spreads continue to run tighter, and debt marches higher. We, as always, take targeted risks in corporate credit, focusing on exposures in organizations with lower cash-flow cyclicality. Within the portfolio, our allocations to the most credit risky class of high yield, CCC-rated credit, sits at a paltry 1%. This is not because there are no opportunities in this area, but given our assessment of relative value of the underlying companies that issue in this space, which is dominated by energy, we’ll take our risks in more opportune venues.
A significant development in corporate credit so far this year has been duration; the average duration of the Bloomberg Barclays U.S. Corporate Index, for example, has increased almost two years since late 2018, to nine years. The trend has further extended this year as borrowers have been aggressive in strengthening liquidity positions and extending the duration profile of their liabilities. Coupled with all-time lows for yields and relatively tight spread levels, this should raise concerns among investors.
The combined effect of longer duration, low yields, and tight spreads does create vulnerabilities for pure corporate bond portfolios; however, we think there are a number of mitigating processes for those with multisector approaches. One such method is balancing intermediate duration corporate exposure with quickly amortizing short-weighted average life asset-backed securities, such as consumer loans, credit card receivables, and auto loans with decent credit enhancements. For example, the effective duration of the corporate portion of the portfolio is currently 3.78 years, while the effective duration of our assetbacked securities is 1.35 years. Appropriately managing risks in a multisector portfolio depends a lot on balance.
Within asset-backed securities, September painted a relatively healthy picture of consumer ABS markets. New issuance volumes last month not only recorded their largest month of issuance so far this year, but were also up versus the September 2019 level. We are keeping a close eye on payment remits and the general health of consumer credit—evidence borrower resiliency in the loan market continues to emerge. While delinquencies have risen slightly for loans with FICO scores above 680, they continue to fall for deals with average FICO scores below 680. There is no “all-clear” signal in ABS, but for those with proven track records in managing risks, attractive yield opportunities await.
The backdrop for agency mortgage-backed securities (MBS) continues to be shaped by the Fed’s guidance, increasing its MBS holdings over the months “at least at the current pace to sustain smooth market functioning and help foster accommodative financial conditions supporting the flow of credit to households.” A strong backdrop for those willing to ride the wave of the Fed’s liquidity tsunami.
Within non-agency, non-qualified mortgage loans have experienced higher delinquencies than other residential credit. Still, the area remains attractive on a risk/return basis. The most recent forbearance report from Black Knight points to the largest single-week decline since the beginning of the pandemic as the first wave of forbearances from April is hitting the end of the initial six-month term. This decline noticeably outpaced the weekly reduction seen when the first wave of cases hit the three-month point back in July. We continue to keep a close eye on potential opportunities here as probabilities for nearterm volatility ahead of the election tick up. Total mortgage exposure in the portfolio, both agency and non-agency, currently sits near 16%.
As we march forward into the end of 2020, we remain focused on our guiding tenet; only take risk when adequately paid to do so. In action, this means staying nimble, focusing on horizon risks, appropriately managing liquidity and most importantly, continuing humility.
Thank you for investing alongside us in Thornburg’s fixed income funds.
Performance data shown represents past performance and is no guarantee of future results. Investment return and principal value will fluctuate so shares, when redeemed, may be worth more or less than their original cost. Current performance may be lower or higher than quoted. For performance current to the most recent month end, see the mutual funds performance page or call 877-215-1330. The maximum sales charge for the Fund’s A shares is 4.50%.