At Boyd Watterson, our fixed income philosophy is centered on our belief that over time, active management can likely generate attractive risk-adjusted returns. We believe this is best achieved by taking a strategic view of macroeconomic and market factors coupled with a value-driven decision-making process and rigorous application of risk-management controls.
Our process focuses on four key sources of excess return or “alpha drivers”: duration, yield curve positioning, sector allocation, and security selection. We will discuss how our strategies are currently positioned around each alpha driver based on the firm’s macro view of the economy while factoring in valuations.
Going back to mid-fourth quarter 2020, we actively transitioned the duration positioning of our core and intermediate strategies from being long duration to short duration, in anticipation of rising interest rates. We decreased the duration from 102.5% of the benchmark to 90%. The reason for moving to a short duration position was that we believed economic activity would likely accelerate as COVID cases declined, vaccine administration increased, and fiscal stimulus would be passed, all of which have happened. The U.S. 10-Year Treasury yield started the year at 0.92% and quickly rose to a high of 1.74% before settling back around the 1.65% level. Given that we expect economic activity to likely continue to improve in 2021, we are maintaining our 90% duration target and anticipate interest rates to head higher. Our range on the 10-year Treasury is now 1.50% to 2.25%
From a yield curve positioning perspective, we are employing a bulleted maturity structure. This means we own more securities in the intermediate part of the yield curve and less on the wings. This type of yield curve structure is usually employed when a steepening of the yield curve is expected, which has happened thus far this year. Short-term interest rates have been mostly anchored at their current levels because the Federal Reserve has made it clear they will not be raising the Fed Funds rate anytime soon. Right now, it is believed that they will likely not raise rates until the middle of 2023. The other advantage of a bulleted yield curve structure compared to a barbell structure is that investors are usually rewarded with additional yield.
Our sector allocation is in line with our macroeconomic view covered earlier. We believe we will likely see strong growth in the second half of 2021. We believe corporate profits in the U.S. will likely be strong and improving along with revenue growth, as companies are coming off a historically low base and earnings comparisons will be an easier hurdle than prior periods. We know corporations took on more debt in 2020, but they have started paying some of that back. Even with valuations on the rich side, we think owning corporate debt looks attractive given other low yielding investment options. In addition, rating agencies are expecting a decreasing number of companies to file for bankruptcy, which means default rates will likely be lower than originally expected, which is beneficial to corporate performance.
For security selection, we use our proprietary credit model to help us select securities that exhibit the attributes that we think are important in determining the credit quality of a company. We look at historical pricing relationships between different industries and factor in fundamentals to determine industry weights. As we moved through the fourth quarter of 2020, we began to rotate from industries and companies that actually thrived during the pandemic into areas that were negatively impacted but would likely rebound as economic growth accelerated. Thus far in 2021, we have seen energy perform well and we expect other cyclical industries such as capital goods and home builders to likely do so as well.
As we move through 2021, we will continue to monitor the macroeconomic environment and assess the four alpha drivers. As new data comes forward, we will review and update our fixed income positions to ensure our macro view is reflected in the positioning of the strategies.
The views expressed herein are presented for informational purposes only and are not intended as a recommendation to invest in any particular asset class or security or as a promise of future performance. The information, opinions, and views contained herein are current only as of the date hereof and are subject to change at any time without prior notice.
Mike Vandenbossche, CFA
Executive Vice President, Chief Investment Officer, Fixed Income
Boyd Watterson Asset Management, LLC