TR Taxable Fixed Income: Fourth-Quarter 2016 Review

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By Daniel Himelberger

In 2016, strong equity markets set record highs throughout the year. At the same time, the fixed-income market saw record lows for the 10-year and 30-year Treasuries and high levels of volatility. The year itself and Cumberland's management decisions were shaped by three major events: Brexit, the election of Donald Trump, and the Federal Open Market Committee's (FOMC) decision to raise short-term rates by 25 bps to 0.50-0.75% on December 14th.

The 2016 Treasury market showed minimal movement. The 10-year and 30-year Treasuries moved up in yield by 30 bps and 11 bps, respectively, to 2.57 and 3.12 percent. This minimal movement took place in a year where we saw record lows on the 10-year and 30-year Treasuries in July, and in November the 10-year Treasury suffered its largest monthly sell-off since 2009. The following table shows the US Treasury Actives Curve, outlining the movements in the Treasury market over the past year.

At the beginning of the year, Cumberland began shortening durations in our taxable fixed-income portfolios after the FOMC decided to raise short-term rates at its December 2015 meeting. Our goal was to start harvesting some profits, as markets were faced with increased odds of a rising interest-rate environment. We accelerated this strategy after the Brexit vote pushed Treasury yields lower. The Brexit-fueled rally marked what Cumberland viewed as the low in rates for the current interest-rate cycle. This view turned out to be accurate, as the Treasury market settled at record lows in the 10-year and 30-year Treasuries, at 1.36% and 2.10%, respectively. These historic lows triggered Cumberland to continue harvesting profits in longer-duration assets and to focus more on preservation of capital by reinvesting cash in short-term, defensive assets. This investment decision turned out to be a positive for Cumberland portfolios as rates began trending upwards following the post-Brexit lows.

From the record lows triggered by Brexit on July 8 to the presidential election on November 8, Treasury yields pushed higher, with the 10-year and 30-year leading the way. The 10-year Treasury was up 49.7 bps to 1.856%, while the 30-year Treasury increased 51.7 bps to 2.61%. Regardless of the election results, market participants expected rates to move higher. With a Clinton victory, expectations were that yields would continue upward at a gradual pace, while a Trump election would result in a brief rally before rates extended upwards at a more pronounced pace, given Trump's infrastructure policy plans. What happened after Trump upset Clinton came as something of a surprise to most market participants. The table below shows the US Treasury Actives Curve, outlining the increase in the Treasury market yield from the lows set by Brexit (7/8/16) to election day (11/8/16).

After Donald Trump collected the 270 electoral votes necessary to secure the presidency, the Treasury market experienced a sharp sell-off. Yields on the 10-year and 30-year Treasuries spiked up 36.4 bps and 34 bps, to 2.22% and 2.95%, respectively in less than one week. From the election to December 16, yields have shot up 75.2 bps to 2.608% on the 10-year and 57 bps to 3.186% on the 30-year Treasuries. It is our view that this move was an overreaction: In less than a month the bond market took rates where they should have gone a year after Trump's election. The drastic overselling of the Treasury market prompted our decision to shorten durations - a positive for Cumberland portfolios. The following table shows the US Treasury Actives Curve, outlining the increase in yield of the Treasury market from the election (11/8/16) to (12/16/16).

With the overselling in the Treasury market, we have taken the opportunity to start easing back into the long end of the curve and have begun extending durations slightly by doing some crossover buying into the tax-free municipals market. The election result has provided an opportunity to purchase long tax-free municipal bonds at yields greater than 4%. At a ratio of 130-140% to the 30-year US Treasury, this represents an attractive opportunity for our clients, so we are including a small weighting in our taxable portfolios. The historical average muni-to-Treasury ratio is 70-80%, and our expectation is that the ratio works its way closer to the historical average going forward.

As we enter 2017, Cumberland's view is that rates will continue moving upward. At the past FOMC meeting on December 14, the decision was made to raise rates by 25 bps to 0.50-0.75%. The Fed also released the latest version of its "dot plot," which is a projection of future interest-rate movements. In this projection the median expectation is for three rate hikes in 2017. We believe there will be at least two, possibly three rate hikes next year. Our goal is to remain defensive in our approach to investing, with a focus on preservation of capital. We will continue making our investment decisions conservatively, while extending durations and picking up some additional yield as the market presents opportunities.