Madison Core Bond: Flexibility within a Risk Managed Framework

A. October 2019

Began to let corporate exposure drop.

Late in 2019 and into 2020, credit valuations had become rich and uncertainties were mounting. We decided to let our exposure to corporate bonds fall. This provided us flexibility for later should the investment outlook become clearer.

 

B. March 2020

Increased credit exposure.

As the COVID-19 crisis began to unfold, corporate bond spreads meaningfully repriced. Bonds from very high-quality companies began to trade at significantly discounted levels, compared to just a few months prior.

As a result, our comfort with owning corporate bonds increased significantly. In late March 2020, our credit committee made the decision to move from an underweight to credit to a significant overweight. Over the following months, our strategies were able to purchase significant positions in high quality corporate bonds at very attractive levels. We also focused on longer maturity bonds to further increase the potential impact of tightening credit spreads on the fund.

 

C. November 2021

Shortened Duration to reduce interest rate risk.

Our view during the latter part of 2021 was that the Federal Reserve would begin a normalization process of monetary policy in 2022. Historically, interest rate increases by the Fed to reduce inflation would end with the Federal Funds rate exceeding the level of inflation, thus creating a positive real Federal Funds rate at the end of the cycle. As 2022 began, the market was still pricing in a Federal Funds rate of only 1.75 to 2.00% by the end of the year, well below the inflation levels at that time.

 

D. February 2022

Reduced MBS exposure.

Early in 2022, the Federal Reserve indicated a desire to normalize monetary policy by raising interest rates in conjunction with a reduction in the amount of bond purchases (quantitative easing), especially mortgage-backed securities (MBS). Our view was that the economic-sensitive buyers would demand higher yields to purchase MBS versus what non-economic buyers would demand (the Fed). As the year progressed, the market began to realize that, indeed, higher spreads and yields would be needed before buyers would step in.

Our active, relative value approach flagged this mispricing, and as a result, the Fund held far fewer MBS. Those that we did hold demonstrated better risk characteristics. Eventually, MBS spreads widened to levels not seen since the financial crisis in 2008-2009. In late 2022, the Fund began to allocate to the sector, as the relative level of interest rates drove these securities to trade at historically significant discounts. As interest rate volatility diminishes, it is our expectation that the relative attractiveness of MBS will bring buyers back into the market.

 

E. March 2023

Added MBS exposure.

During the second quarter of 2023, due to liquidity issues within the banking sector, spreads on MBS widened significantly. Investors feared a large amount of selling by banks to raise cash in case of deposit flight. Additionally, quantitative tightening continued, thus increasing MBS supply to the market.

Our view was that the current level of spreads provided value both on an absolute and relative basis. The level of pricing would attract flow from investors, given the relative underweight to the asset class. Additionally, the Fund was underweight low coupon MBS due to Fed and bank ownership leaving spreads too tight. Low coupon MBS was the area of the market that widened the most, allowing the Fund to buy bonds with attractive characteristics and low payups.