During the third quarter of 2021, ULST outperformed the Bloomberg Barclays US Treasury Bellwethers 3 Month Index on both a NAV and market price basis.
During the third quarter, ULST outperformed its benchmark largely due to its over-weight allocation to investment grade corporate credit. The moderation of US economic activity, due largely to a rise in COVID-19 cases from the Delta variant, and expectations of a modest pivot of US monetary policy in the fourth quarter of 2021, left investment-grade credit spreads largely unchanged during the quarter. For example, Bloomberg Barclays Floating Rate Note Index (FRN) spreads tightened by 1 basis point (bps) during the quarter, producing positive price and carry excess returns versus the fund’s benchmark, while the credit curve hardly changed, with BBB FRN spreads unchanged and 2 bps wider versus AAA and AA FRNs, respectively.
During the quarter, the increase of COVID-19 cases due to the Delta variant moderated US economic activity. In combination with this slowdown of economic activity, the prospects of the Federal Reserve (the “Fed”) tapering their quantitative easing (QE) program during the fourth quarter of 2021 led to a very modest tightening of US financial conditions.
For example, during the quarter, the above-mentioned FRN Index spread tightened 1 bps, the Bloomberg Barclays US Credit Index spread widened by 3 bps, and the Bloomberg Barclays US High Yield Index spread widened by 21 bps.
Similarly, the US stock market ended the quarter little changed quarter-over-quarter, and VIX, a measure of implied volatility for the stock market, picked up quarter-over-quarter. This very modest tightening of US financial conditions occurred within the context of greater than expected signs of inflation in the US economy, which, given the unique nature of a recovery from a pandemic, is expected to be transitory.
In terms of Fed monetary policy, the Fed Funds Rate remains near the zero-lower-bound and the Fed’s balance sheet grew by nearly $400 billion during the quarter, with purchases made directly in US Treasury and US Agency mortgage-backed securities (MBS). The market is currently pricing in just one Fed Funds rate hike out to December 2022, and only two more out to December 2023; signs that the market understands the dovish ramifications of the Fed’s more flexible monetary policy framework, established August 2020.
Portfolio Positioning and Outlook
Source: Bloomberg Finance L.P., January 31, 2020 – September 30, 2021. The above targets are estimates based on certain assumptions and analysis made by Bloomberg Finance L.P., There is no guarantee that the estimates will be achieved.
Our fundamental active fixed income investment process has three components: structural, cyclical, and tactical. Our analysis of structural economic growth trends, which includes demographic trends, the trend growth rate of the labor force, and the trend growth rate of productivity – and the potentially negative effects of COVID-19 on each of these factors – suggest to us a US trend growth rate of less than 2.0%. As a result, our structural analysis suggests that interest rates will remain historically low. But there are reasons for optimism regarding the US’s structural trend growth prospects.
First, on the heels of the American Rescue Plan Act, the White House announced plans to introduce major US infrastructure legislation. In addition, the discovery and rapid distribution of multiple COVID-19 vaccines should limit the negative impact of COVID-19 on the above structural economic growth trends. Finally, there are signs that pent-up private sector investment may accelerate in the coming quarters. Taken together, these catalysts could improve US structural trend growth, which has been in secular decline for some time, but we remain in the early innings for each of these factors. As such, our historically low interest rate outlook holds.
Our analysis of cyclical trends focuses on economic activity momentum as well as policies that can serve to either extend or contract the economic cycle. As mentioned above, improvements in economic activity and the labor market were negatively impacted by the COVID-19 Delta variant, but we expect an improvement in those trends for the balance of 2021 into 2022, as we’ve already seen the current wave of Delta variant COVID-19 cases decline significantly. We also expect continued government support for the economy in the form of substantial monetary stimulus, even as the Fed likely begins tapering QE in the fourth quarter of 2021. Housing continues to be a powerful engine for the economy’s recovery as mortgage rates remain near all-time lows. Private sector investment should improve in the back half of 2021, especially in the form of inventory restocking. Finally, as mentioned above, US government stimulus has created very easy financial conditions, which serves to support the economy’s expansion.
Given the zero-lower-bound achieved in Fed Funds, we are positioned below the Fund’s strategic duration risk target of 0.50. The Fund’s duration was largely unchanged, from 0.29 to 0.30, quarter-over-quarter. Regarding our asset allocation strategy, we’re maintaining a diversified exposure to corporate industrials and financials, prime asset-backed securities (ABS) credit cards and autos, and commercial mortgage-backed securities (CMBS). Our credit allocation to BBB-rated credit is at 24%, which is roughly in the context of our long-term strategic exposure for this strategy. The strategy has a 2.0% allocation to BB-rated credit (which is an allocation used primarily for the optimal management of fallen angels).
Asset allocation shifts included a 3% reduction in ABS, a 2% increase in CMBS, and a 2% increase in Financial Institutions. Within the complicated context of a reduction of COVID-19 Delta variant cases and a Fed that is expected to modestly begin tapering QE in the fourth quarter, our view is that the combination of continued economic growth and the careful unwind of monetary policy stimulus will continue to support credit spreads in the near-term. At current valuations, the significant incremental yield offered by the portfolio versus its benchmark, which had a yield of just 4 bps at the end of the quarter, should produce positive excess returns for the balance of 2021.
|Security Type||Fund (%)||Index (%)|
|Commercial Mortgage-Backed Securities||9.7||0.0|
Source: State Street Global Advisors, as of September 30, 2021. Asset allocation is a method of diversification that positions assets among major investment categories. Asset allocation may be used in an effort to manage risk and enhance returns. It does not, however, guarantee a profit or protect against loss.
|Credit Rating||Fund (%)||Index (%)|
|AAA Rated or Above||33.3||100.0|
Source: State Street Global Advisors, as of September 30, 2021. Ratings are based on the Bloomberg Barclays Composite Rating.
Basis Point (bps)
A unit of measure for interest rates, investment performance, pricing of investment services and other percentages in finance. One basis point is equal to one-hundredth of 1 percent, or 0.01%.
Bloomberg Barclays US Corporate High Yield Index
An unmanaged index that is comprised of issues that meet the following criteria: at least $150 million par value outstanding, maximum credit rating of Ba1 (including defaulted issues) and at least one year to maturity.
Bloomberg Barclays US Credit Index
An index that measures the investment grade, US dollar-denominated, fixed-rate, taxable corporate and government related bond markets.
Bloomberg Barclays US Dollar Floating Rate Note Index
An index that measures the performance of floating rate bonds issued by the US Treasury.
Bloomberg Barclays US Treasury Bellwether 3-Month Index
An unmanaged index representing the on-the-run (most recently auctioned) US Treasury bill with 3 months’ maturity.
Investing involves risk including the risk of loss of principal.
The views expressed in this material are the views of James Palmieri through the period ended September 30, 2021 and are subject to change based on market and other conditions. This document contains certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected.
This communication is not intended to be an investment recommendation or investment advice and should not be relied upon as such.
The whole or any part of this work may not be reproduced, copied or transmitted or any of its contents disclosed to third parties without SSGA’s express written consent.
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