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4Q
Investment Report
US Long Duration Full Discretion
2 0 1 6
Interest Rate Trends
Yield Curve
Interest rates surged over the quarter as markets anticipated higher US
growth and inflation stemming from the upcoming fiscal policy transition.
While 5s-to-bonds (as depicted below) ended the quarter a few bps flatter,
the overall yield curve steepened as shorter-dated bonds (0-3 years) rose
much less than long-dated issues.
5-Year to 30-Year Spread
Spread Between 5- and 30-Yr. UST Yield (bps)
5
Treasury Yields
Yield to Maturity (%)
4
3
30-Year Treasury Yields
2
1
5-Year Treasury Yields
0
-1
2008
3-Month Treasury Yields
2009
2010
2011
2012
2013
2014
2015
300
250
200
150
100
2016
Source: Bloomberg
Source: Bloomberg. As of 31 Dec 16
50
0
2008
2009
2010
2011
2012
2013
2014
2015
2016
Source: Bloomberg
Source: Bloomberg. As of 31 Dec 16
Credit Spreads
Long Credit Subsector Spreads
Spreads ended the quarter at tighter levels.
Other than sovereigns, spreads for all subsectors finished the quarter at
tighter levels.
325
300
275
Basis Points
Basis Points
280
Long Credit Index Spreads
260
240
220
U.S. Long Credit
200
180
160
140
U.S. Intermediate Credit
120
100
80
60
Jan 13 May 13 Sep 13 Jan 14 May 14 Sep 14 Jan 15 May 15 Sep 15 Jan 16 May 16 Sep 16
Fed Watch: Evolution of Median FOMC Member Interest Rate
Forecasts
Long Sovereign
200
175
US Long
Corp ex Fins
150
-
Long Taxable Municipal: US Aggregate Eligible
125
100
Jan 13 May 13 Sep 13 Jan 14 May 14 Sep 14 Jan 15 May 15 Sep 15 Jan 16 May 16 Sep 16
Source: Bloomberg Barclays
Source: Bloomberg Barclays. As of 31 Dec 16
IG: Financial
250 Institutions –
225 Long
Source: Bloomberg Barclays
Source: Bloomberg Barclays. As of 31 Dec 16
4Q16 Fixed-Income Returns
Most spread sectors posted positive excess returns in 4Q16.
The FOMC raised interest rates during its December meeting and moderately
increased its forecast of 2017 rate hikes from two to three.
4.0
Dec '16 FOMC Meeting Predictions
3.5
Excess Return (%)
3.0
Percent
2.5
2.0
1.5
1.0
Dec '16 FOMC Meeting
0.5
0.0
End 2016
End 2017
End 2018
End 2019
Long Run
Source: Federal Reserve. As of 14 Dec 16
Source: Federal Reserve. As of 14 Dec 16
Note: FOMC = Federal Open Market Committee
6
5
4
3
2
1
0
-1
-2
-3
-4
-5
-6
4.4
1.9
Excess Return %
3.3
2.4
Total Return %
(Treasuries)
4.1
2.3
1.1
0.0
-0.4
-1.8
-4.1 -4.4
Govt Corp Long Mtge TIPS Non-$ EMD
Corp
Hedged
Sectors
HY
Long
Govt
Credit
2
5
10
Maturity
(years)
-3.9
30
-3.4
30
(strip)
Source: Bloomberg Barclays, J.P. Morgan, Western Asset
Source: Bloomberg Barclays, JPMorgan, Western Asset. As of 31 Dec 16
US Long Duration Full Discretion
PERFORMANCE SCORECARD
We thought that …
Therefore, we …
Central banks would remain highly accommodative and growth and inflation would
remain subdued. Therefore, UST rates were
likely to remain low. Duration also served as
a useful hedge for spread product exposures.
Covered the mild duration overweight fol- – Yields ended the quarter at higher
lowing the election.
levels.
The potential changing nature of monetary
policy could exert upward pressure on the
long end of the yield curve.
Maintained a steepener bias in the long end – The curve flattened somewhat over
the quarter.
of the curve.
The US agencies, FNMA and FHLMC, would
continue to gradually improve their finances.
Maintained an overweight to long-end se- +/–The overall strategy did not have a
nior debt.
meaningful impact on relative performance this quarter.
Although corporate earnings could weaken modestly in the near term, the technical tailwinds should remain very positive
for US credit.
Maintained a modest underweight in long – Long corporate spreads ended the
quarter at tighter levels; however, subinvestment-grade corporate credit.
sector and issue selection offset part
of the drag.
Non-corporate credits, primarily consisting
of Canadian provincials and long educational bonds, offered value.
Maintained a small overweight.
Certain states within the municipal market faced pension-related fiscal challenges
and overall there was better relative value
elsewhere.
Maintained the modest underweight to tax- +/– Municipal spreads tightened over the
able municipals.
quarter; however, issue selection offset most of that drag.
High-yield corporate fundamentals were
sound and valuations were attractive.
Maintained the modest position in high- + High-yield spreads tightened.
yield exposure.
The housing market continued to be supported by a slow easing of the tight credit
conditions in play since 2008, which limited
new supply and enticed demand.
Maintained the overweight to non-agency + Spreads tightened during the quarter.
RMBS.
Emerging market bonds were exiting a deep
bear market and would benefit from improving fundamentals and favorable technical tailwinds.
Maintained corporate and local currency + Spreads tightened during the quarter.
exposure.
Long swap spreads would widen into yearend.
Reduced the duration-hedged 30-year payer + Long swap spreads widened toward
positions.
the end of the quarter.
Short euro and Chinese yuan currency positions would serve as a macro-hedges against
policy errors and volatility from those areas.
Where allowed, maintained a short euro and + The US dollar strengthened following
yuan position and added a long Mexican
the election.
peso position near quarter-end as valuations
looked attractive.
Western Asset
And the results …
2
+ Issue selection within this strategy was
a small contributor to outperformance.
Fourth Quarter 2016
US Long Duration Full Discretion
OUTLOOK
Our thesis since the financial crisis has been that the global recovery would be ongoing but very slow by historical standards. In
2016, our view remained that US and global growth were going
to be steady but unspectacular and that it would be sufficient
to give us some ongoing forward momentum. Combined with
a backdrop of subdued global inflation, central banks would increase accommodative monetary policies and this would help
provide the support for an ongoing recovery. Our working
premise has been a trend growth rate of roughly 1.5% for the
US and just under 3% for the global economy. In order to take
advantage of the ongoing global and US recoveries, a healthy
amount of our risk budget was devoted to spread product, in
the belief that slow growth, if sustained, would be sufficient to
bring down various credit spreads. We have also utilized macro
strategies, particularly overweights to duration that have helped
protect the portfolio during risk-off periods, while also benefiting from the slow pace of interest-rate normalization.
abroad while after many years of increasing supply, expectations
are now for a deceleration in the pace of new issues as we head
into 2017. Against this we remain vigilant about global issues that
could come off the backburner such as Chinese growth and political events and policy errors in Europe. Overall, the base case
view for credit spreads remains a tighter destination in the near
to mid term, but the aggressive move tighter in spreads over the
past many months have valuations nearing what can only be described as fair.
The largest sector bias of the Firm’s credit portfolios, an overweight to financials, remains, but the magnitude has been reduced over the back half of the year. US and global bank regulation is well advanced and we view more regulation as generally
good for bank bondholders. The incoming administration could
relax the regulatory environment but Democrats are unlikely to
allow wholesale changes to Dodd-Frank. Longer term, a looser
regulatory environment could arguably be worse for bondholders but near term we resist the notion that changes will be dramatic enough to materially impact the domestic banking business model. US banks generated record revenues and earnings
in 3Q16 and near-term bank performance will continue to be
closely linked to domestic GDP performance.
The market’s optimistic growth expectations since the US presidential election is based on policies that could come over the
next 12-18 months, though the bond market has already raised
interest rates today. Can the global and US economies fulfill
those accelerated projections? It was not quite a year ago that
optimism about US growth led the Federal Reserve to forecast
four rate hikes in 2016, only to see China fears and global growth
concerns lead to a very different outcome. While the markets appear to be pricing in an imminent uptrend for the economy, the
economic releases over the past few months largely remained
on trend. Overall the US economy is showing better growth than
the 1.3% GDP growth pace that occurred from mid-2015 through
mid-2016, but we think that improvement is less dramatic than
what has become baked into market pricing. The evolution of
Trump’s economic policies will be crucial. Our view is that the
jury is still very much out. Igniting US growth in the context of a
very weak global environment has proven exceedingly difficult.
Trump’s trade policies are potentially negative for global growth.
The implications of labeling China a currency manipulator and
the erection of trade barriers may reinforce the global risk-off
episodes we have seen intermittently over the last five years.
We continue to view the overall market as being in the latter half
of the credit cycle and are cautious about the potential for further M&A and shareholder-friendly activities in certain sectors. As
such we are generally maintaining an underweight to technology and healthcare/pharmaceuticals. Commodity sectors such
as energy and metals and mining have passed through the end
of their cycles and are in deleveraging mode. We shifted to an
overweight in energy earlier this year and remain comfortable
holding this position as many issuers continue to take the necessary steps toward rightsizing their operations. On the margin we
are reducing exposure in the telecommunications/media space
on concerns over M&A activity and we are also reducing auto
exposure. Overall, the strategy is still constructive on spreads and
overweight beta, but given the significant improvement in valuations since the first quarter, the magnitude of this tilt has been
significantly reduced.
On the credit front, the fundamental backdrop for credit is mixed
as there are late cycle indications (e.g., earnings growth is challenged, leverage is rising); however, new fiscal and political developments could be supportive of growth and credit friendly.
The technical tailwind remains favorable as demand is expected
to remain firm given investor flows from lower-yielding markets
Western Asset
While taking some profits on non-agency mortgages and other
securitized issues, a sizable-yet-reduced allocation remains on a
duration-hedged basis as we feel this sector remains attractive
given the carry advantage over similar quality instruments. On
the margin, emerging market fundamentals are improving and
3
Fourth Quarter 2016
US Long Duration Full Discretion
we believe we have seen the bottom after a multi-year bear market. Within emerging markets we see more value in corporate
and local currency exposure as opposed to dollar denominated
sovereign exposure. Modest short positions in the euro and Chinese yuan also remain serving as a macro hedges against volatility emanating from those areas. The long-held underweight to
taxable municipals remains. With regard to the agency sector,
we believe the underlying fundamentals are still supportive. A
curve-steepener bias on the long end of the US Treasury curve
also remains. In addition to the positive carry feature in the current environment, the potentially changing nature of monetary
policy, while still accommodative and aggressive, may exert upward pressure on the long end of the curve.
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reproduced or used in any form or medium without express written permission.
Past results are not indicative of future investment results. This publication is for informational purposes only and reflects the current opinions of Western Asset Management. Information contained herein is believed to be accurate, but cannot be guaranteed. Opinions represented are not intended as an offer or solicitation with respect to the purchase or sale of any
security and are subject to change without notice. Statements in this material should not be considered investment advice. Employees and/or clients of Western Asset Management
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For more information on Western Asset visit our website at www.westernasset.com.
Western Asset
4
Fourth Quarter 2016