MARKET COMMENTARY

Starving for Yield at the Siege of Constitution Avenue…

08.26.2020 - Jeffrey S. MacDonald, CFA

Webster’s official definition of a siege is “a military blockade of a city or fortified place to compel it to surrender.” 

Armies have used this strategy for centuries to overtake a target with a very defensible, but concentrated position. Sieges in Leningrad, Vicksburg (Mississippi), Sevastopol, the island of Tyre, Gibraltar and many others over the years took place, in some cases, with varying levels of success.  When they did work, starvation and disease within the city generally carried the day, forcing the inhabitants to either surrender or be overrun by the aggressor. 

In any case, all of these sieges and others have a common thread: Select a target you want to attack, drive them back, trap them within their fortified position, surround them with all the weapons and resources you have at your disposal…and wait…and wait…and wait.

The Federal Reserve is Waging a War of Its Own

The Fed is adopting a similar siege approach in terms of setting policy at its headquarters on Constitution Avenue in Washington, DC. The “target” is the Fed’s dual mandate of price stability and full employment. In true siege fashion, the Fed’s offensive in March in the wake of the Covid-19 shutdown was nothing short of awesome and total.

The Fed immediately brought its traditional tools of zero policy rates and balance sheet purchases of mortgages and Treasuries to the front lines. It soon followed these actions with a new set of weapons that injected credit support into every corner of the US economy, including money markets, corporate credit, small- and medium-sized businesses, and state and local governments.  The Fed now has the dual mandate surrounded, and appears ready to wait for surrender for as long as it takes.

Meanwhile, the good citizens of Yield City are left starving, trying to find places to put capital to work that provide at least some level of acceptable income. And the questions that are part of almost every conversation with investors are “How long will the siege last?” and “What are we supposed to do in the meantime?”

Here at Fiduciary, our clients are asking the same questions, and we thought a few answers were warranted at this point.

How long is the Fed siege going to last?

The Federal Reserve is in no hurry to raise rates or tighten policy in the foreseeable future.  Comments from Chair Powell along the lines of “We’re not even talking about raising rates” suggest that any discussion about a change in policy is probably at least a 2021 development and would lead an actual change by six months or more. 

Unlike the previous tightening cycle in 2018, it appears that a greater tolerance for inflation and inflation expectations is baked into the committee’s current thinking. Shorter maturity yields are likely anchored at least until late 2021. Given the massive stimulus/support recently introduced on both the fiscal and monetary side, we could argue that longer maturity yields could drift higher in advance of this, responding to concerns about a snap back in growth and inflation in coming years.  The US TIPS market, a good gauge of market-based inflation expectations, has begun to suggest just such an outcome.

Where can we find income in the meantime?
  • Cash

First, we need to acknowledge the environment that we are in. Most money market cash instruments are yielding close to zero. Treasury bills don’t yield much more. That said, if you need overnight, guaranteed liquidity for a short-term obligation like a tax bill or house closing, our recommendation is to accept these meager yields in return for the liquidity and safety of TBills and cash. 

If you don’t have a near-term liquidity need, we have developed some short, high quality solutions, for elevated cash balances, where we can generate some excess yield relative to Tbills and cash and still provide safety and liquidity consistent with a cash-like instrument.

  • Municipal Bonds

The municipal market has rallied meaningfully since March in response to the support of the Fed, making it very challenging to find attractive yield in the sector. 

Even with the Fed support, we cannot ignore the fundamental challenges state and local governments face on the front lines of the pandemic. Therefore, we believe in being selective with respect to credit. While front end rates should be fixed for some time, longer maturity rates could potentially drift higher if inflation expectations continue to rise. 

With limited compensation for taking on elevated credit or interest rate risk, we recommend investors avoid zero-yielding cash and stay invested in shorter, higher quality bonds that offer incremental yield and flexibility should the environment change.

  • Corporate Bonds

Both investment grade and high yield bonds have rallied since market lows in March. Issuers have used this market strength to issue a record amount of debt to build war chests of liquidity to weather the current storm. 

We added investment-grade and high-yield corporate bonds to portfolios in March, and this shift performed well. Today, spreads are at levels where the attractiveness lies in their incremental yield over government securities, rather than an expectation of spread tightening leading to outperformance for the sector. We continue to favor credit but, like munis, it remains important to keep a very close eye on both interest rate and credit risk.

Focusing on Safety and Income

The Siege of Constitution Avenue will be in place for the foreseeable future. At Fiduciary Trust, we recognize this. Rather than moving aggressively into riskier parts of the fixed income market, we are encouraging clients to stay focused on the role of fixed income to provide safety and income in a multi-sector portfolio.

We prefer to maintain the safety characteristics of the asset class and subsist on what income we can creatively derive in the current market until the "target" surrenders. 

 

 

 

 



The information provided is intended solely to provide general information. The information and opinions stated may change without notice. The information and opinions do not represent a complete analysis of every material fact regarding any market, industry, sector or security. Statements of fact have been obtained from sources deemed reliable, but no representation is made as to their completeness or accuracy. The opinions expressed are not intended as individual investment, tax or estate planning advice or as a recommendation of any particular security, strategy, or investment product. Please consult your personal advisor to determine whether this information may be appropriate for you. This information is provided solely for insight into our general management philosophy and process. Historical performance does not guarantee future results and results may differ over future time periods.

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