March 31, 2014
The first quarter saw spreads in the credit markets continue to compress, with high yield as the big outperformer across asset classes despite a very strong 2013. Financials also had a strong run to close out 2013 and continued to do well in 2014. Spreads across credit markets widened at the end of January, with financials widening by about 20 bps, but now many of the investment grade corporate credits are marking post-crisis tights. Earnings came in better than expected in the fourth quarter and fundamental performance combined with a generally improving macroeconomic outlook drove credit spreads tighter. Additionally, strong technicals have helped support credit spreads, such as demand for corporate credit by pensions and institutional investors rebalancing into fixed income after such a dismal fixed income absolute performance in 2013 and such a strong US equity market performance. With much of the prior year's market moves revolving around both policy uncertainty at the Fed, and a potential government shut down as the debt ceiling limit loomed, stocks and other risk assets rallied into the end of the year as the market received some more direction regarding both major issues. That rally only temporarily paused as spreads widened alongside the mini stock correction in the first quarter of about 6%. Spreads were also a bit weaker in early March on some of the Ukraine news regarding Crimea, but the credit markets have shook off both events and are now tighter than the start of the year. The VIX declined substantially since the government debt ceiling resolution and amidst strong equity market performance but rose off of the crisis in the Ukraine and Crimea. It is now at 15.18, well off the lows around 12 in the trailing 12 months. Volatility, as measured by the VIX, has correlated closely with higher beta credit spreads and high yield spreads.
Bonds rallied in the first quarter after experiencing the worst sell-off in 2013 since 1994. The 10 year US Treasury yield finished 1Q 2014 at 2.72% after ending 2013 at 3.03%. Still, the 10 year yield is north of its 2013 average of 2.33% and well north of its low of 1.39% in July of 2012. Most of the Treasury losses in 2013 were experienced in the second quarter as the market reacted negatively to Fed Chairman Bernanke's comments related to ending or "tapering" their MBS and US Treasury asset purchases. The return on the Ryan Labs 10-year Treasury Index was 3.08% after posting a -7.73% in 2013. Many of the reasons behind the bond sell-off earlier in the year remain in place, such as the fear regarding the eventual unwinding of the Fed's multiyear QE program and better macroeconomic indicators. However, the real yield is still dramatically improved from earlier in 2013, as inflation has remained extremely low but the 10 year yield is still over 100 bps higher than in May of last year. Although the macro economy looks like it is improving, data in the first quarter was generally mixed. The awful winter was blamed for many of the weaker-than-expected prints such as the dreadful +74K print on changes in nonfarm payrolls for December 2013 released in January. The most recent March jobs number came in much closer to expectations, at +192K versus an expected +200K.
Within high-grade fixed income, credit spreads in the Barclays Aggregate Index ended 2011 at 217 bps, 2012 at 133 bps, tightened to 111 bps to end 2013, and finished the first quarter of 2014 grinding tighter to 103 bps. Spreads were tighter even in the midst of a mostly sideways equity market and mixed macroeconomic data. Spreads on financial credit ended the first quarter of 2014 at 103 bps. This was after a strong 2013 that saw financial spreads end the year at 109 bps from 155 bps off Treasuries to end 2012. Industrial spreads ended the quarter tighter as well, finishing out the quarter at 105 bps. Industrials closed out 2012 at 133 bps, and continued to tighten to 114 bps to end 2013. The agency MBS sector underperformed duration-neutral Treasuries for the first quarter, even as the yield curve flattened. The excess returns of the agency MBS sector was -24 bps versus duration-matched Treasuries and the option-adjusted spread at the end of the quarter was 38 bps. With the Fed slowly stepping away from making outright purchases in the sector, the MBS sector has looked for a new equilibrium pricing.