During the second quarter, interest rates moved along the path of least resistance and rose across the curve. More pressure was felt at the front end of the Treasury curve as the Fed continued raising interest rates. The increase in rates at the long end of the curve was held in check over concerns about the distinct slowdown in the global synchronized growth story and benign inflation expectations. As a result, the yield curve continued its flattening trend, with the spread between the 2- and 10-year Treasury ending the quarter at 33bps.
The credit sectors had an interesting quarter, especially when examining the investment grade and high yield segments of the market. Within investment grade, lower quality underperformed higher quality as reduced foreign demand and escalating trade tensions put pressure on credit spreads. However, the opposite was true on the high yield side, as lower quality significantly outperformed higher quality due to less technical pressures and reduced supply.
The securitized sectors showed resilience during the quarter and escaped some of the underperformance shown in the credit sectors. Agency mortgage-backed, commercial mortgage-backed, and asset-backed securities all outperformed Treasuries and generated positive excess returns.
We are approaching the second half of 2018 positioned for higher interest rates and flat-to-tighter spreads. Our focus continues to be on income generation and maintaining a yield advantage relative to the benchmark. A summary of our main fixed income investment views and themes is listed below:
- Our forecast for four rate hikes aligns with FOMC expectations, although the strength of the dollar and economic activity outside the U.S. may start to have greater influence on the timing and path of future Fed activity
- We expect short-term rates to increase more than long-term rates, leading to a flatter yield curve
- Credit valuations have cheapened and are fairly valued by most measures. Credit technicals have been weakening, but fundamentals remain very supportive
- Credit should be overweighted based on income generation and modest spread-narrowing expectations
- Floating-rate notes remain a good way to take advantage of anticipated rising short-term rates
- TIPS provide an inexpensive option to mitigate against an unexpected increase in inflation