Boston - Eaton Vance and its affiliates seek to actively capitalize on opportunities presented by uncertainty about future market and economic outcomes, while ensuring that the portfolio risk profile remains appropriate for the specific strategy. Here are excerpts from a recent conversation with Andrew Szczurowski, CFA, Portfolio Manager at Eaton Vance Management.
What we are seeing: While there may be elevated volatility in most markets around the world right now, one place that is seeing little movement is the short end of the US Treasury curve. At their June meeting, US monetary policymakers updated "dot plot" forecasts for the federal funds rate. What was a bit surprising was that 15 of the 17 Federal Open Market Committee (FOMC) members saw no rate hikes through at least 2022.
Admittedly, the current environment makes it really challenging to predict economic growth a few months from now — let alone in 2022. But if the last decade has taught us anything, it is that the Fed is going to err on the side of providing too much stimulus, rather than too little, and then deal with the consequences at a later date. So while investors have a lot to worry about right now from coronavirus trends and trade wars to the upcoming election, one thing they don't have to worry about is the Fed hiking rates.
When we see the 2-year US Treasury yield on June 23 at 0.19% —almost the same level as on April 15 at 0.20% — it makes sense that the yield isn't moving higher if the Fed has all but said they won't be hiking rates for at least 2.5 years. It is also hard for yields on the short end to move lower when policymakers are not in favor of cutting the fed funds rate into negative territory.
The Fed has always controlled the short end of the US Treasury curve, but the long end is still the Wild West. While the Fed has sought to manage the long end through actions like QE and Operation Twist, it has never truly tamed it. Longer-end US Treasury yields will continue to bounce around on news of vaccines, fiscal stimulus, tariffs and seemingly lastly these days... economic data.
What we are doing: We remain pessimistic that the economic recovery will live up to the market's lofty expectations. Given how much risk markets have bounced off their lows, we believe the skew is tilted toward the downside. A successful strategy for many investors for years has been to invest where the Fed is investing, not try to fight it. After the Fed's recent foray into investment grade corporate bonds, many investors have followed it there with great success.
The spread for the one to three year investment grade corporate index has tightened from 306 basis points (bps) over US Treasurys on March 31, to 178 bps on April 30, to just 93 bps as of June 23. Meanwhile, spreads in the AAA-rated government agency mortgage-backed security (MBS) market have gone from 126 bps over US Treasurys on March 31 to 102 bps on April 30, and have since widened back out to 117 bps as of June 23.
Investors in A and AA short-end investment grade corporate bonds are now receiving less spread than they would investing in a comparable duration AAA agency MBS. With the widening in agency MBS spreads over the last seven weeks as investment grade credit spreads have ground tighter, this sector now lets investors move up in quality and yield at the same time. We have been adding agency MBS that offer prepay protection if mortgage rates continue to hit new lows, as we suspect they will.
What we are watching: We are watching to see whether Bloomberg Barclays US Aggregate Index-based investors continue with their insatiable demand for investment grade corporate bonds. Or will they start to take gains now that spreads have reversed the bulk of their March widening, and rotate back into higher quality sectors like agency MBS and US Treasurys?
Final word: In such an uncertain economic environment, it is important for investors to be nimble, not taking on additional credit and liquidity risk if they aren't being compensated to do so. Agency MBS once again looks very compelling to us, relative to higher quality investment grade. With spreads sitting well above their five-year average, and the largest holder of agency MBS — that is, the Fed — buying bonds daily, we think MBS spreads are poised to outperform.