Published on January 20th, 2022
Fourth Quarter 2021 | Fixed Income Commentary
The Current Income Portfolio declined 0.54% gross during the fourth quarter. Corporate bonds, which make up roughly 73% of the portfolio, declined 0.82%, while preferred securities, which comprised roughly 23% of the portfolio, gained 0.27%. Within the preferred securities allocation, retail securities, which have both fixed and fixed-to-floating rate coupons, accounted for 70% while institutional securities, which only have fixed-to-floating rate coupons, made up the remainder. The portfolio’s retail preferred securities gained 0.73% during the quarter and the institutional preferred securities declined 0.91%. The Bloomberg Barclays Intermediate US Corporate Bond Index, and Intermediate US Govt/Credit Index, declined 0.55% and 0.57%, respectively. The BofA Fixed Rate Preferred Securities Index, which is made up of 40% institutional and 60% retail preferred securities, was essentially unchanged for the quarter.
Fixed income markets started the quarter on a positive note, with many companies reporting better than expected corporate earnings and many macroeconomic indicators, such as consumer confidence, labor force participation and unemployment claims, showing signs of further economic recovery. As the quarter progressed, however, consumer prices continued to climb as shortages and bottlenecks showed little sign of easing. According to the Bureau of Labor Statistics, the Consumer Price Index rose by 6.2% in October, and by 6.8% in November, the largest 12 month increase in four decades.
With a wave of new cases of the Omicron variant starting to surge across the country in late November, fears of additional government lockdowns and prolonged inflationary pressures deepened. As a result, the Federal Reserve officials began to signal a more hawkish outlook for monetary policy. In a senate hearing on Nov. 30th, Federal Reserve Chairman Powell acknowledged that inflation has been “broad” and “more persistent” than previously anticipated, and that the committee would consider tapering asset purchases at a faster pace than the current $15B per month.
At December’s FOMC meeting, the Federal Reserve took further tightening action. Chairman Powell revised the committee’s tapering plan higher to $30B per month, and to conclude the bond buying program three months earlier, in March of 2022. A faster end to tapering also meant an earlier “lift-off” by the Federal Reserve in raising interest rates, as median dot plot forecasts were revised upward to reflect three hikes in 2022, three in 2023, and eight interest rate hikes in total by 2024.
During the quarter, the yield curve underwent a bear flattener shift whereby interest rates rose by more in the front-end than in the intermediate and long-term segments of the curve. By the end of the quarter, two-year U.S. Treasury yields had increased by 46 bps, to reflect the perceived earlier interest rate hikes, while ten-year yields increased by just 2 bps. This flattening in the slope of the yield curve caused shorter duration securities to decline to a greater degree than intermediate and longer-term duration securities. As a result, CIP’s corporate bonds, which have a shorter duration than the intermediate-term US investment grade corporate bond market, experienced a greater decline than that of the respective index. In addition, when the yield curve flattens, it can also have a slightly negative effect on fixed-to-floating rate securities. While higher interest rates generally increase the value of the securities’ floating-rate coupon component, the average period before which the Current Income Portfolio’s securities begin to float is approximately three years. Therefore, any increases in the yields for maturities of up to three years can still negatively impact the portfolio’s fixed-to-floating rate securities via the fixed-rate component.
Fourth Quarter Increase in 2Y and 10Y US Treasury Yields
Given our belief that expectations for earlier timing and a greater number of interest rate hikes have now been priced into the yield curve by investors, it seems likely that much of the expected decline from rising interest rates is already “baked into” current prices of securities in the portfolio. For further portfolio deterioration to continue from changes in the yield curve, interest rates would need to exceed what current hawkish projections imply. Therefore, we believe the Current Income Portfolio is well positioned to withstand the several interest rate hikes that are currently projected for this year. Should expectations for an even more aggressive hiking cycle materialize, the portfolio’s relatively short duration should limit the severity of any impact from changes in interest rates and the inclusion of fixed to floating rate preferred securities provides offsetting interest rate exposure to fixed-rate coupons, which in turn lowers overall portfolio volatility.
In our view, credit conditions should remain benign in the near to intermediate term. Companies continue to have strong balance sheets, solid corporate earnings, and, because of the many refinancing’s that took place in recent years at historically low interest rates, some of the highest interest coverage ratios since 2015. We continue to monitor the credit and interest rate environments and believe the portfolio is appropriately positioned to earn enhanced income without taking on excessive risk to do so.
As of December 31, 2021