Beyond cutting rates, the Fed also went much further, as we described earlier in this Commentary. It announced several billion dollars of asset purchases – for the first time targeting corporate and municipal bonds in addition to treasury and mortgage bonds. Other central banks around the world have announced similar measures as part of a coordinated global response. The already bloated Fed balance sheet could double from four trillion dollars to as much as nine trillion dollars as it intervenes to stabilize and backstop the bond market. While the Fed’s action echoes the prior financial crisis of 2008 / 2009, the root causes of the problem are different. During the financial crisis, the underlying concern was credit and counterparty risk – the fear that corporations and banks, in particular, did not have sufficient assets to meet their financial obligations. This time, banks are very well capitalized and there is less leverage in the financial system.
The issue the Fed is targeting currently is not credit risk but liquidity risk. With trading in the bond market relatively thin and demand for high quality liquid assets very high, bond prices generally fell during the quarter. This is not necessarily indicative of greater default risk, but rather a function of the “buyer’s strike” also described earlier. By stepping in to support the market, the Fed has helped stabilize prices, which will likely encourage other investors to step back in as well, allowing for (ironically) more freely functioning markets and better price transparency.
Our investment approach to Fixed Income remains consistent. We are focusing on the highest quality sectors of the bond market, which includes U.S. government agencies, high-grade corporate bonds, and high-quality municipal bonds. We are not especially concerned about the recent price volatility in the bonds we own because in most cases we hold bonds until they mature, at which time clients receive back the full principal along with interest due.
We are encouraged by better market conditions and better liquidity in the weeks following the Fed’s stabilization efforts. Though yields have fallen sharply, we still see fixed income investments as having a proper place in a diversified portfolio for clients who need capital preservation and income, and as a means of lowering overall portfolio volatility.