The Bond Market: 1st Quarter 2020


Liquidity, liquidity, who’s got the liquidity? Readers of somewhere around my years may re­member playing the child’s game ‘button, button, who’s got the button?’, though it has its roots as far back as the late 1800s. In the game, only one child ends up with the button. As for the Federal Reserve in the current economic crisis brought on by COVID-19, everyone gets liquid­it


“Quality, income, asset allocation – and liquidity – have always been and will always be our main objectives as we actively manage our clients’ fixed income portfolios.”

In March, the Fed restarted – or created – pro­grams from the financial crisis of 2008/2009 to pump billions of dollars into the system. Some of them include: 

  • Quantitative Easing – purchases of Treasury securities for as long as needed
  • Primary and Secondary Corporate Bond Credit Facilities – loan issuance for new and outstand­ing bonds
  • Asset-backed Loan Facility – for securities like car loans, student debt, and credit cards
  • Money Market Mutual Fund Facility – to keep cash investments safe and liquid
  • Commercial Paper Funding Facility – purchasing commercial paper to aid money market funds
  • Main Street Funding Facility – to bolster SBA lending

Think of liquidity as the movement of money through the financial system which facilitates secu­rities being bought and sold quickly and without much price disparity. When liquidity “dries up,” sellers still have a price in mind from recent trading, but buyers all of a sudden put a much lower value on the security. The bid/offer spreads widen and if you really, really need to sell: ouch! 

From the onset we viewed the volatility in the fixed income markets to be a result of a lack of liquidity and not a credit or financial system problem. We understand our clients’ concerns, but we don’t want to just sell securities at any price to raise cash for comfort. While we are adjusting our asset alloca­tion to increase equity exposure, we are identify­ing fixed income securities as a source of cash. The economy going forward will be different for certain sectors. Airlines, for example, are taking a big and immediate hit, though they stand to recover with the overall economy. Business travel, and leisure travel to a degree, should rebound relatively quickly. The cruise industry, for comparison, will probably recover much more slowly as it is primarily leisure travel. We consider these differences, along with pricing, credit quality changes – and liquidity – as we determine which fixed income securities are potential sale can­didates. 

The same is true for clients’ municipal bond portfo­lios. I think it is best to say right up front that we con­tinue to view the sector as a safe haven fixed income allocation. Volatility jumped to historic levels very quickly, but we can trace that back to forced selling by ETFs and mutual funds. The municipal bond mar­ket has indeed changed over the past decade, much of it due to tax law changes which made the tax-free nature of municipal bonds less advantageous for institutional investors and more advantageous for retail investors. The growth in assets in ETFs and mutual funds is just one byproduct of those changes. Redemptions require the ETFs and mutual funds to sell; and redemptions were extraordinarily high as March came to a close. Redemptions have already abated, and a much more balanced bid/offer tone has returned.e broader fixed income market, the Bloomberg Barclays US Aggregate Index returned 18 basis points for the fourth quarter—another breather quarter of a 2019 that saw an 8.72% full-year return. The slowing performance in the fourth quarter was mainly due to government securities. All indications were for a Treasury market ahead of itself when 10-year yields fell through 1.5% at the end of August last year. Treasury yields drifted higher throughout the fourth quarter with the 10-year Treasury ending the year at 1.92%. Coupon income balanced the price drop of intermediate Treasuries, providing a total return of only a few basis points. On the other hand, intermediate credit kept up its impressive quarterly performance with almost a 1% gain in the fourth quarter. Any amount of issuance was met with very strong demand. Similar to taxable bonds, tax-free bonds can have a disparity between sectors like unlimited tax, general obligation, and water and sewer revenue bonds, versus bonds backed by transportation systems or hotel taxes. Our long-standing practice of purchas­ing large, high quality issuers has allowed us to steer clear of the smaller, less secure names. And we follow the same thoughtful process of evaluating sale can­didates based on ratings, current pricing, and liquid­ity as we slowly reallocate to equities.  

To finish up, this would not be a true Quarterly Com­mentary if we didn’t provide some sector returns. For the Bloomberg Barclays Intermediate Govern­ment/Credit Index, our benchmark for total return accounts, the first quarter returned 2.40%. What was thought to be a relatively quiet start to the year turned into a Treasury rally of historic proportions. With the index holding two-thirds of its value in Gov­ernment securities – much of it is Treasuries – it was bound to be tough to keep pace in client accounts. As we continue our slight over-weight to credit to capture a higher level of current income, total return may continue to trail for the near term. The Bloom­berg Barclays Quality Intermediate Index, our bench­mark for tax-free portfolios, returned -.35% for the first quarter. We maintain our client tax-free accounts at a generally higher quality than the index which is an important characteristic in the current state of af­fairs in the U.S. economy. One point to keep in mind, though, is that high quality bonds continue to pay coupons and mature at par even though they always experience price fluctuations during the life of the security. 

Big picture: the returns – positive or negative – are quite small when compared to riskier assets. Quality, income, asset allocation – and liquidity – have always been and will always be our main objectives as we actively manage our clients’ fixed income portfolios.

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