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Following stellar bond market returns in the first quarter, institutional investors are now adjusting fixed income portfolios to reflect their views on the likelihood of a U.S. recession, according to a new report from State Street Global Advisors. (Spoiler alert: Investors are not yet betting on a recession.)

The global quarterly report Bond Compass leverages analysis from State Street Global Markets showing bond flows and holdings indicators from the first quarter of 2019, taken from a data set of $10 trillion of fixed income assets under custody and administration at State Street.

Investors began the year with near neutral returns in Treasuries, but have rapidly chased returns this quarter. The report finds that demand for Treasuries surged into the top quartile as investors chased returns, but they did so primarily at the front end of the curve.

“Few expected central banks to capitulate on monetary tightening quite as quickly as they did in Q1,” the report states. “As a consequence, long-term investors were not prepared for the stellar bond market returns that followed.”

According to the report, aggregate demand for U.S. Treasuries hit a 12-month high at the end of March .

The report notes this demand has not come entirely at the expense of riskier fixed income instruments. While demand for U.S. mortgage-backed securities and investment grade corporates remained robust, high yield bonds did see some outflows in the quarter, according to the report.

Maturity Outlook

The report also looks at the demand for U.S. Treasuries across different maturity buckets.

“The debate between policy response, reflation and recession is perhaps best captured in the slope of the U.S. yield curve,” the report states. “The brief inversion of the 3-month, 10-year yield spread has certainly boosted fears of recession given the signal’s track record in the post-war era.”

The report finds that the pattern of investor flows across different curve maturities is “telling.”

“While aggregate demand for Treasuries was as strong as it was a year ago, demand across the curve is very different today,” the report states.

Demand for Treasuries at the front end of the curve — which rose to a five-year high during the quarter — has led this year’s surge, according to the report. Notably, this trend stands in contrast to 2018, when demand was entirely led by appetite for the longer-dated Treasuries.

“Just as there was a clear desire to lengthen portfolio duration last year, so there is a desire to shorten duration today,” the report states.

Also of note, demand for the belly of the curve — which State Street says typically performs well during recessionary periods — has so far been relatively neutral.

“So investors are enthusiastically buying Treasuries,” the report states. “Although, they are not betting on a recession just yet, and are reluctant to add to their overweight at the long end of the curve at these yield levels.”

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