December 2022

We’re delighted to communicate that the Halyard Reserve Cash Management (RCM) composite generated a positive net return of 0.72% for 2022.  During a year in which nearly every risk asset fell in value, we are delighted with that outcome.  That’s not to say that the composite didn’t suffer some interim mark-to-market losses as the Federal Reserve defied expectations and raised the overnight lending rate by 400 basis points.  The composite endured an unprecedented six mark-to-market losing months last year despite the Halyard team’s highly conservative duration management. A comparison of 2022 U.S. Treasury total returns, according to Bloomberg, follows:

Halyard RCM composite 0.72%
ICE BofA 2-year U.S. Treasury Index -4.2%
ICE BofA 10-year U.S. Treasury Index -16.3%
ICE BofA 30-year U.S. Treasury Index -33.4%

By keeping the weighted average duration of the composite accounts short, we were able to reinvest at higher yields with each successive Fed rate hike.  The negative impact on performance stopped in October and the strategy paid off nicely in November and December.  As we commence 2023, we deem the short maturity fixed income as offering the most attractive return/risk profile in over 15 years.  To take advantage of the opportunity, we’ve begun to extend duration in an attempt to lock-in these attractive yields.  However, given the distinct possibility of a recession this year and the ill effects of a downturn on lower-rated corporations, we’ve improved the credit quality of the portfolio such that the weighted average credit rating is “A” and the weighted average yield to maturity is 4.88%.

As we commence the new year, the markets continue to demonstrate the volatility that was present for most of December.  The 30-year bond, which closed out 2022 at 3.96% has already traded 30 basis points lower, touching 3.66% during the month.  For leveraged buyers, namely banks and hedge funds, this is pertinent in that to earn 3.66% they need to borrow at 4.34% generating a net negative carry of -0.68% for a one-year holding period.  Backing into the math, such a buyer of the long bond will need to offset nearly 12 points of negative carry.  Over the course 2023, the leveraged 30-year position will need to fall to approximately 3.16% for the trade to makes sense.  We discuss the negative carry trade to illustrate that the current shape of the yield curve is going to be problematic for the bond market in general.  Until late last year the carry spread was positive, meaning that the trade generated revenue for the holders, assuming they were able to effectively hedge the negative price sensitivity of the trade.  That relationship is no longer attractive.  Moreover, the entire curve from the 3-year maturity to the long bond is currently inverted, creating an uneconomical situation for the leveraged buyer.

It’s difficult to predict how the inversion will impact the market aside from keeping bond price volatility elevated as bond longs and shorts play cat and mouse to try to capture short-term price movement without incurring significant negative carry.  At least on paper that seems to be the opportunity.  In practice the inversion is likely to reduce demand for longer-dated securities and the situation will ultimately correct itself.  But one wonders how much economic pain leveraged buyers are willing to assume.

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