"What a difference a year makes." It's a phrase that might often be considered cliché — except for those with firsthand experience of the investment extremes of the past 12 months. The pessimism and fear so rampant a year ago as an economic hurricane was crashing across the world from a virus-induced global shutdown has been replaced with optimism and hope of economic revival. Stock prices have generally soared, and most bond prices (U.S. Treasuries being the exception) have more than recovered from the markdowns in those darker, scarier days a year ago.
The first quarter continued the positive trend of economic good news — but provided evidence reinforcing our year-end comments and warnings about low forward return prospects and why investment starting points matter. Without so much as a hint of the Federal Reserve withdrawing or tapering its support of the U.S. bond market (namely, keeping short-term interest rates at zero and buying $120 billion a month of primarily government securities), bond investors decided to throw a version of 2013's taper tantrum and vote with their feet (sell) as economic strength and/or inflation concerns weighed on sentiment. The result was an acceleration of a move upward in longer-term U.S. Treasury interest rates that began last summer, albeit from historically low levels. For context, the 30-year Treasury had the worst first-quarter return since 1919, and investment-grade bonds (whose valuation always begins from a Treasury rate) had their worst first quarter return since 1980.
Weitz fixed income funds held their own in the first quarter. The Weitz Short Duration Income Fund posted positive results and the Weitz Core Plus Income Fund, while down modestly, posted strong relative quarterly returns compared to its index. The key driver to both funds' outperformance in the quarter was having positioned them with historic low duration, in the case of Weitz Short Duration Income, and meaningfully less duration than its index or peers, in the case of Weitz Core Plus Income. Further detail about contributors to performance can be found in each fixed income fund's quarterly commentary.
Fixed-Income Market Update
The graph below shows the changes of select Treasury rates over the past quarter and year.
U.S. TREASURY YIELDS
Source: Bloomberg
The Treasury curve steepened meaningfully in the first quarter as longer rates (particularly 10- and 30-year) rose. The 10-year Treasury rate has more than doubled from where it was a year ago and has risen significantly since year-end. The 30-year Treasury rate increased nearly 50% in the quarter, precipitating its worst first-quarter return in over 100 years. Shorter rates (0- to 3-year) remained anchored close to zero given the Fed's resolve to leave the Fed Funds rate at or near zero.
Spreads on corporate bonds continued to decline modestly in the first quarter. A broad measure of investment-grade corporate bond spreads, compiled by ICE BofA, continued their decline in the quarter -- from 103 basis points as of December 31 to 97 basis points on March 31. Declining corporate bond spread resulted in slight relative outperformance compared to U.S. Treasury bonds. This was small comfort for most corporate bond investors as investment-grade bonds still experienced their worst first-quarter return in decades. The chart below depicts the path of investment-grade credit spreads for the past 5 years (blue line) against the one- (orange) and five-year (gray) averages.
INVESTMENT-GRADE CREDIT SPREADS
Source: Federal Reserve Economic Data (FRED) — St. Louis Fed
Overall, investment-grade corporate bond credit spreads are well below their 1- and 5-year averages and are only 7 basis points above the post-Great Recession lows set in early 2018. Viewed from an even longer time frame of 10 years, investment grade corporate bond credit spreads have rarely been as low as they were at quarter end. Using daily data from the St. Louis Federal Reserve Economic Data, investment-grade corporate spreads have only been lower than Q1's 97 basis points 1.6% of the time, or 43 out of 2,610 total observations. Economic optimism could plausibly push spreads even lower, but history is certainly not on its side.
The table below provides a view of the changes for the broad investment-grade and high-yield universes that have transpired over the past year, as reported by ICE BofA. Yields and spreads have declined meaningfully, benefitting bond investors, including our bond funds, but the declines have left forward return prospects in yet another tough starting place.
| INVESTMENT-GRADE | HIGH YIELD | |
|---|---|---|
| YIELD TO WORST | YIELD TO WORST | |
| 03/31/20 | 3.69% | 9.24% |
| 03/31/21 | 2.30% | 4.27% |
| OPTION ADJUSTED SPREAD (OAS) | OPTION ADJUSTED SPREAD (OAS) | |
| 03/31/20 | +305 | +877 |
| 03/31/21 | +97 | +336 |
Outlook
"The future should be viewed not as a fixed outcome that's destined to happen and capable of being predicted, but as a range of possibilities and, hopefully on a basis of insight into their respective likelihoods, as a probability distribution." — Howard Marks (Trades, Portfolio), Oaktree Capital
"Success in investing doesn't correlate with I.Q. once you're above the level of 125. Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people into trouble in investing." — Warren Buffett (Trades, Portfolio), Berkshire Hathaway Inc.
The two quotes above by very successful investors seemed fitting to place within the context of an outlook section. 'Outlooks,' by their nature, are simply guesses about a very unpredictable future. But those guesses can and should be informed by the current environment and relative to history. While we have cheered the year-to-date rise in base rates (U.S. Treasury) since it modestly improves forward return prospects, we are sober enough to realize that 10-year Treasury rates of less than 2% are still woefully low by historic standards — especially should inflation rear its long-dormant head. Couple this with credit spreads, especially investment-grade, that are at or near 10-year lows, we think it prudent to remain defensive. With respect to interest rate risk, we believe we have positioned our funds defensively by maintaining low duration. We will continue to strive to maintain the right 'temperament' that has historically allowed us to take advantage of the 'pitches' (preferably fat ones) that the markets invariably offer us and grow/learn in areas that are complementary to our core investment process.
Our fixed income funds have flexible mandates that allow us to navigate any environment by identifying the most favorable investment opportunities wherever we can find them. Just as important, we have the freedom to avoid areas where price and value appear the least favorable — which have recently been those areas most influenced by price-insensitive index investors and Fed intervention.
Our goals are to (a) preserve capital, (b) maintain a strong liquidity position, (c) understand evolving risks and opportunities, (e) conduct consistent/thorough credit surveillance, and (d) selectively take advantage of favorable risk/reward opportunities. These have long been and will continue to be our investment marching orders. We believe keeping these objectives front of mind while maintaining the 'temperament,' as referenced in Mr. Buffett's quote, should continue to serve us and our fellow investors well in the quarters and years ahead.
For more on our market outlook, we encourage you to read Wally and Brad's latest Value Matters, and for additional information regarding first quarter portfolio activity and current positioning, please see the fund commentaries on our website. We remain ready to take advantage of valuation disparities that may develop and hope to continue to earn your trust.
The opinions expressed are those of Weitz Investment Management and are not meant as investment advice or to predict or project the future performance of any investment product. The opinions are current through the publication date, are subject to change at any time based on market and other current conditions, and no forecasts can be guaranteed. This commentary is being provided as a general source of information and is not intended as a recommendation to purchase, sell, or hold any specific security or to engage in any investment strategy. Investment decisions should always be made based on an investor's specific objectives, financial needs, risk tolerance and time horizon.
