The long-awaited reopening of the U.S. economy started to become a reality during the second quarter, with vaccines administered to the broader population, resulting in COVID cases and deaths falling rapidly and mask restrictions being lifted across the country. Annualized GDP growth for the first quarter, released in April, came in at 6.4%, setting the stage for full year 2021 growth to register at levels not seen in many decades. The recovery in the labor market continued, and though May’s non-farm payroll release of 266K fell well short of elevated expectations, the economy has approximately nine million open jobs employers are searching to fill. If those positions were filled, economists estimate the unemployment rate would be back to pre-pandemic levels of 3.5%. Despite slack in the labor market, it was the inflation story that received the most attention during the quarter. Inflation prints accelerated in both the U.S. and Europe, sparking a fierce debate about how persistent the trend will be, and how serious central banks should take it.
The Federal Reserve, for its part, signaled throughout much of the quarter that rising inflation is expected to be transitory and should normalize as base effects wane and supply/demand imbalances work themselves out. As widely expected, in its June meeting, the FOMC kept rates unchanged at zero and maintained its pace of asset purchases. Despite maintaining the status quo, there was a notable shift in the forecast for future hikes, with the FOMC’s “dot plot” showing members expecting two Fed Funds rate increases in 2023. The market reacted to this “hawkish” signal by flattening the Treasury curve, effectively pricing in less future expected inflation. The 10-year Treasury yield ended the quarter at 1.47%, 27 basis points (bps) lower versus the end of March, while the 2-year Treasury rose by nine bps to finish at 0.25%.
Inflationary fears did not put a dent in fixed income credit sectors, as strong fundamentals gave investors reason to push spreads even tighter. Investment-grade corporate spreads, as measured by the Bloomberg Barclays U.S. Corporate Index, ended the quarter at 80 bps, a level 56 bps through its 10-year average and which represents the sector’s post-financial crisis tights. Similarly, high yield spreads grinded tighter despite increased supply and sector outflows. In a measure of the low risk aversion investors are feeling right now, the spread between CCC-rated bonds and BB issues fell to 261 bps, well below the past decade average of 504 bps. Valuations at these levels more than suggest that the reopening trade has been fully priced in at this point.
Second-Quarter 2021 Performance Highlights
- The Thornburg Limited Term Income Strategy achieved a positive return for the second quarter of 0.91%, slightly underperforming the Bloomberg Barclays (BBG) Intermediate Government/Credit Index, which returned 0.98%. Over a 12-month period, the strategy gained 1.82% versus 0.19% for the index.
- Our allocation within the asset-backed securities (ABS) space proved to be beneficial, with a bias toward bonds backed by auto and consumer loans. Meanwhile, the strategy’s exposure to corporate credit was neither a significant contributor nor laggard to returns. We have preferred to stay relatively defensive in an environment where investment-grade corporates spreads continue to grind tighter and the sector once again outperformed Treasuries for the quarter.
- The strategy’s structural short duration position versus the index was a slight detractor to relative performance in a modestly falling rate environment. During the quarter, the five- and 10-year Treasury yields fell by 5 and 27 bps, respectively. Duration positioning proved to be the only notable detractor within the strategy over the three-month period.
Current Positioning and Outlook
The downward drift in intermediate-term Treasury yields during the second quarter seems to indicate that the market is looking past the current inflation chatter and believes that inflation trends will moderate, or that the Fed has maintained credibility with investors and can deal with the potential issue. While we expect FOMC members to speak publicly about the potential timing of QE reduction in the coming months, we do not anticipate another ‘Taper Tantrum’ like the market experienced in 2013. It can be argued that rates already rose in response to an eventual “taper” in asset purchases, but the strength of the recovery protected investors from the “tantrum” created by a sell-off in risk assets. That said, we have reduced portfolio duration modestly, preferring to be more defensive if trends in wage inflation persist and the Fed is forced to respond faster with rate hikes. Ultimately, the inflation picture remains hazy, and it will be several months before the fog lifts and visibility improves.
In corporate credit space, low rates have encouraged an increase in corporate borrowing, with investment grade gross leverage at near record levels and interest coverage trending downward. Spreads remain resilient, however, with fund flows into the sector consistently positive on a week-by-week basis. In such an environment, our preference is to stay up in quality and own securities which exhibit less sensitivity to changes in credit spreads. The flattening of the curve further dampens the case to move out the maturity spectrum in search of additional yield.
With corporate valuations less compelling, we find good relative value in the securitized sectors, particularly within ABS space. Coming out of COVID, the consumer balance sheet is robust, with increased aggregate savings, higher home prices, and stimulus payments providing a strong fundamental tailwind. In a similar vein, we are constructive on residential mortgage credit, as prudent lending standards provide strong protection to bondholders. Overall, we prefer to own shorter duration exposure, particularly within ABS, which in many cases has competing spreads to longer duration corporates but with less rate risk.
Thank you for investing in Thornburg’s fixed income strategies.