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    20170411 CMO - Is It Three or is It Two

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    Investment report

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    © All Rights Reserved
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    40 views4 pages

    CMO - Is It Three or Is It Two

    Uploaded by

    RCS_CFA
    Investment report

    Copyright:

    © All Rights Reserved
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    of 4
    “ClO REPORTS The Weekly Letter > Bonds still matter: Even with expectations of rising interest rates, we view bonds as essental to a diversified investment strategy Fixed income is a diversifying asset class that typically exhibits less volatlty than equities and a low or negative correlation to them: It also generates steady income regardless of price gyrations. n fact, we see these benefits as particularly important given ‘the current macro uncertainty. Stacks may help you dream; bonds should help you sleep. > Markets in Review: Equities fell last week with the S&P 500 losing 0.2% and international ‘equities, as represented by the MSCI EAFE Index, fling 0.7%. Bond prices gained, with the 10-year ‘Treasury yield at 2.38%, slightly down from 2.39% on Friday of the prior week. Commodities. ‘overall, as measured by the Bloomberg Commodity Index, added 0.69 as WTI crude rose 3296 to ‘$52.20, while gold appreciated by 0.4% to $1,254:50 per ounce. APRIL, 2007 Chlet Investment Office Matthew Diezok Managing Director Fued income Strategist Mary Ann Bartels Head of Mert Lynch Wealth Management Potato Strategy Elizabeth A, MacGregor oalys, Rodrige C. Serrano ‘ce President Recent Publications eo Loer ~ Looking Ahead: This week investors wil ook tothe Univesity of Michigan Consumer Sentiment Whe BAT 9? Index for April wich has been tending higher on expectations for stronger growth bolstered by «Mom Ltr : “eo much Greving ad ofing improving wage gains, and the Bureau of Labor Statistics’ Consumer Price Index for February. cee In the Eurozone, Eurostat fs set to repor Industrial Production for February (See page 3) The Mads of March Bonds still matter Cone NvESTMENT ASSET CLASS OFFICE VIEW Walt no more. We have Final seen fim signs of what Federal Reserve govemors are calling policy normaization—a move aoe FREE SNS CEE further up and aay from the zero bound, where the benchmark — federal funds rate was for the better part of the decade, eo ueeeee | US. Municipals et ee Where we've been ies Since the beginning of the year, economic data has conveyed io Uiveeumete eee ee better growth story, with consumer confidence, business US. High Yield [oe ‘and investment sentiment and housing data ticking upwards. This growth supported the Fed's move on March 15 to lft the ‘overnight fed funds rate by 0.25% to a target range of 0.75% to 1.00%. That marked the third increase in this cycle, and the Fed signaled two more this year. Our base case is Fora gradual increase in the 10-year Treasury yield to 3% by later this year or early 2018, an increase we suspect will come in fits and stats. ‘So what does this mean for fixed income? Improving economic, fundamentals, increasing sensitivity to market sentiment and slightly faster Fed tightening have already brought a number of developments—higher nominal rates, higher real rates, a scarcity of volatility tightening spreads between the yields of investment grade debt and Treasures, a continued rally forthe high yield sector with both yields cropping and spreads compressing and, luckily steady returns on municipal securities. Historically, the 10-year Treasury yield has risen 1.346 on average from the beginning to the end of a hiking cycle, which implies a terminal yield of about 3.6% in the current cycle, Given Fridays yield of 23896, almost all of this expected rise is stll ahead of us, and therefore we continue to favor fixed income strategies that are slightly short in terms of duration — the sensitivity of prices to changes in interest rates. Anather lesson from history is that the yield curve typically flattens during a rate hike cycle, This flattening reflects the restraining effect of Fed policy on the economy in its efforts to keep inflation from spiraling upward, We recommend a barbell strategy—favoring the short and long ends of the yield curve—given the expectation of one that's higher and flatter and as the belly of the curve usually underperforms. Men yc Wealth Manageme kes aaa products and series fered ty Mel Lynch, Plc, Feoet& Sth Incrporated ovesument roc: BS Merrill Lynch (NLPF4S} a else troke- dealer nd Member SIPC and athe subsidiaries of Bank of America Corporation (BofA Cop, ani of America Crpevation ‘re Not FDIC Insured ‘Are Not Bank Guaranteed May Lose Value (© 2017 Bank of Aerie Corporation Argh reserved ee A look at sectors Investment Grade: We remain slighty overweight US. Investment Grade. We see an improving economic backcop, ‘transparency with the Fed, potential pro-businesses fiscal policies, from Washington and positive yield diferentials compared with the rest ofthe world, However we have become more cautious on credit as valuations have become more stretched. Modest spread tightening could support low single-digit retums, but we expect it is unlikely those spreads will tighten to 2005 levels given higher durations and deterioration in credit quality cover the last decade. We caution that spreads appear closer to reflecting fair value, and excess retums are already near our fullyear targets. Therefore, wth rates having more room to rise, investors should prepare for increasing volatility of total returns. High Yield: We are underweight corporate High Yield. Spreads are well below average levels forthe sector as a whole and for every credit category within it, with prospective retums for the buy-and-hold investor hovering in the mid-to-low 3% range. Yields ‘are quite low by historical standards and are barely covering average credit losses for bonds rated CCC and below. We saw a “Fear of Missing out” attitude throughout February and March, However, BofA Merrill Lynch (BofAML) Global Research notes that in the last few weeks we have started to see wobbles in High Yield that started as the effects of rate risk on higher-quality yields before being unexpectedly compounded by lower oll prices and deterioration in optimism leading to a modest sell-off. While this reversal could just be a blip, BofAML. Global Research, cautions it could be the late-spring sel-off we anticipated! Given allof these developments, we think the risk/reward tradeof is Unfavorable, and there is litle margin of safety for the risk-averse, long-term investor. For the portion of funds stil invested in High Yield, we recommend that most investors stay up in quality ‘Municipals: We are overweight Munis as they remain a foundational portfolio element in taxable accounts for high-tax-bracket investors, Ratios of Municipal yelds to those of ‘Treasuries have tightened on shorter-maturity Issues, although ‘Munis got alittle cheaper after the Fed hiked rates in March and spreads on 10-year issues have widened and continue to look attractive. Longer-term munis are relatively cheap, suggesting investors are demanding additional compensation For the risk that the value of the tax exertion will be reduced by tax reform. BofAML Global Research expects tax reform will likely isappoint investors. The organization is thinking that markets will continue to rally until we see more solid proposals?f tax reform stalls and individual income tax cuts are more modest, the upside for munis could be even greater. Lastly the volume of outstanding municipal bonds has decreased since 2010, a positive technical factor. We believe credit spreads for A-rated bonds provide an attractive risk-adjusted opportunity while on the short end, variable-rate demand notes provide a competitive rewun Is it 3% or is it 2%? What's the next stop for the 10-year Treasury yield? The presidential election in November was folowed by a selLoff in fixed income investments, exemplified by the benchmark To-year US. Treasury yield rising from 1.85% to 2.058 the following day. Expectations for rising inflation were sharply heightened by the increased likelihood ofthe passage of pro-business lg[slation. This development complemented discernable signs of a smchronized global expansion, which had ‘already been driving a rebound in inflation or refaton, since the summer. Continued reflation would drive the Federal Reserve towards continued ‘normalization’ ofits monetary policy. By mid-December the 10-year Treasury yield hissed 2.60%, a level that’s become dificult to breach, Weighing on its rise Is growing skepticism regarding the ‘extent and sustainability of reflation. The fallure of the Trump ‘administration to revamp the health insurance system has raised doubts about whether it can unite contentious factions within Congress to pass tax reform, a more pertinent issue for investors. In addition, there's been an unusual, much-debated divergence ‘between bright “Soft data,” which generally consists of surveys. ‘gauging economic sentiment, and more subdued “hard data,” or more concrete measures of performance, From the standpoint of technical analysis, the competing forces of sustainable versus non-sustainable rflaton have kept the 10-year Treasury yield within a range of 2.30% to 2.60% ‘Abreak higher would point the way to 3.00%, a significant top in late 2013, as the next potential technical battleground While this scenario may reflect a less antagonistic atmosphere in Washington, we belleve more importantly it would signal higher growth in the global economy, which may translate into higher prices for commodities and other assets, further fueling reflation. Corwersely, a sustained break below 230% would bring 2.0096 into view as the next signpost, prompting head-scratching from investors bearish on bonds over the longer-term sustainability of higher infation and growth. While a break above or below may not prove this decisive, it could mark a technically notable event that deserves examination. " BolA ML Global Research, "The HY We: FOMO NOM March 23,2017. “BofA ML Glaal Reseach “TheHY Wve Oot bed” ApS 2017 —— Markets in Review 1» The Federal Reserve released its Open Market Committee minutes, hich portrayed the Fed as relatively hawkish. Fed officials have Indicated there may be a

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