Sector Rotation: The Cornerstone of Our Investment Grade Strategy
Volatility can be challenging but it also creates opportunities. In our view, rotating across sectors within the investment grade market is the most effective way to take advantage of price fluctuations and generate alpha.
The volatility within the investment grade (IG) fixed income universe over the first three months of 2023 has been a blessing for investors like us. Our strategy seeks to capitalize on the behavioral differences between the three major sectors within the investment grade universe – U.S. Treasuries, corporate bonds, and agency mortgage-backed securities (MBS). By rotating across these groups, we attempt to generate alpha and deliver better risk-adjusted returns than the Bloomberg U.S. Aggregate Index (Agg).
One Investment Grade Market, Three Distinct Asset Classes
The investment grade bond market is unlike equities or high yield fixed income, as each major sector provides exposure to a unique and differentiated risk/return profile. U.S. Treasuries are considered the ultimate safe haven asset and are typically in high demand during periods of market distress. Performance is driven by moves in interest rates and economic/inflation expectations. The agency MBS sector, more specifically agency pass-throughs, is made up of Treasury-like amortizing bonds that allow investors to express views on homeowner prepayment behaviors driven by the level and volatility of interest rates. And finally, the corporate bond sector allows investors to gain exposure to the credit risk of corporations that use leverage to finance their business activities. Because each sector is sensitive to different economic and market factors, the IG market provides investors with diverse sources of return. At the end of February 2023, these three sectors made up over 93% of the Bloomberg Aggregate Index.
Investors who have not closely followed the investment grade universe tend to think of it as homogenous, but that is rarely the case. Since 2003, the difference between the best and worst performing of the three sectors averaged 5.48%. An extreme example of this was in 2008, during the peak of the Great Financial Crisis, when Treasuries significantly outperformed corporates as investors clamored for safety. That year, the total return of the U.S. Treasury sector was 18.67% greater than the corporate sector.
Taking advantage of these divergent returns is the cornerstone of our investment strategy. We are constantly monitoring the investment grade market, looking for opportunities to increase exposure to sectors that present compelling relative value.