Fixed Income Q2 2016
The shift in sentiment that occurred in in the second half of the first quarter of 2016 continued to drive the market recovery from the lows we saw in mid-February. However, as we progressed through the second quarter, markets increasingly focused on the upcoming U.K. referendum vote on its membership in the European Union (also known as “Brexit”), which became one of the main drivers of daily market movements. Overall, the market priced in much greater odds of a “remain” vote than those reflected in the polls or on the various betting sites. In the evening of June 23, as polls started to come in, this optimism quickly shifted toward concern and uncertainty as it became clear that the U.K. had voted to exit the EU.
Remarkably, the market started to trade higher as June closed, as it became apparent that Article 50, the legal document required to be delivered to Brussels to formally initiate the exit process, would not be filed until later in the year, or perhaps much later. It is still unclear when the process might be initiated, but the uncertainty that took over the market on the evening of the vote, quickly dissipated and money began to flow back into the market.
Naturally, market volatility has been elevated. The U.S. 10-year bond started the quarter with a yield of 1.77%, traded as high as 1.93% before dropping sharply after the Brexit vote to 1.36%, and ending the quarter at 1.47%. Concern in the market has been around the risks associated with the global growth and inflation outlook. At the moment, globally, one-third of all sovereign debt is trading at negative yields, meaning that investors are willing to buy assets that guarantee they will lose money if held to maturity, rather than taking on risk that could lead to losing more money. These are truly unprecedented times, with equity markets at new all-time highs and interest rates at all-time lows. In such a low-yield environment, investors are being forced to take on more risk than they have historically in the hopes of achieving their financial goals. For many, the idea of investing in sovereign debt at historically low levels is absurd, so money will continue to flow into assets classes like equities and high yield, which should remain supportive of these asset classes.
Interest rate sensitive products, such as government bonds, performed better than most sub-asset classes of the bond market as interest rates moved lower on the back of Brexit fears. Longer-duration (interest rate sensitivity) assets performed best as investors scrambled for the safety of bonds. Now, the risk is that those same assets may suffer as cash and risk appetite return to the market. Obviously, European holdings came under pressure as a result of uncertainty surrounding the Brexit vote. It is unclear what the U.K.’s vote will mean for the EU and its other member countries over the long term.
The Front Street Tactical Bond Fund retuned +1.4% during the second quarter, but had been doing much better prior to the Brexit vote. We, like most of the market, had positioned the portfolio for what seemed like the most likely outcome, a “remain” vote. When this did not occur, performance suffered during the last week of June, the fund losing much of the performance earned earlier in the quarter.
Given the recovery that occurred from the lows in February, we took profit on a number of the fund’s positions and moved into assets that offered better relative value than those positions exited. We were very active trading rates given the opportunities created from volatility in the markets.
We believe that money will flow back into the market and into corporate debt, given that investors’ appetite for yield cannot be achieved in sovereign debt. This should prove to be very supportive of yield spreads, and allow the fund to achieve a decent return. At the beginning of 2016, our outlook was for 4%-5% total return for this strategy. Despite the ever-changing global economic outlook, our expectation for 2016 returns for the fund remain the same.