CIP Update: The Best Offense is a Good Defense
Published on December 21st, 2021
US Treasury yields have been volatile this year, but overall have moved higher, and the rising interest rate environment has had a negative impact on many fixed income assets. Bond math dictates that the higher the duration (effectively, the longer the maturity) of a fixed-rate coupon security, the greater the decline in value will be from an increase in interest rates. Other factors affecting the value of fixed income portfolios include the relative change in a security’s credit spread, (which can be caused by macroeconomic factors as well as security-specific factors), and the overall allocation to various types of coupons, including those with both fixed and variable-rates.
In general, when a security’s credit spread declines, its value appreciates to reflect the issuer’s lower risk of default. In addition, when a security’s coupon structure is fixed for a period, and then floats after a certain date is reached, its value can appreciate even as interest rates rise or the yield curve steepens. By carefully selecting high quality, undervalued issuers that offer attractive compensation in terms of “credit spread”, a fixed income portfolio can benefit from credit spread tightening regardless of the ensuing interest rate environment. Furthermore, by including an allocation to fixed-to-floating rate coupon securities within the portfolio, that portfolio’s overall sensitivity to changes in government yields can be significantly reduced as fixed rate and fixed-to-floating rate exposures offset each other.
In the process of portfolio construction for the Current Income Portfolio, we attempt to apply a risk-conscious approach that considers each of the aforementioned factors. We believe the resulting portfolio is a unique blend of high-quality corporate bond and preferred securities, diversified by industry and sector, with a shorter duration than respective intermediate-term fixed income indices and lower overall sensitivity to changes in interest rates.
The success of this risk-adjusted approach is supported by the relative outperformance of the portfolio versus benchmark indices so far this year. The Intermediate-term US Gov/Credit Index, which is comprised of government securities and investment grade corporate bonds, with an overall duration of 4.1, has declined by 1.3% through December 17th, while the Intermediate-term US Corporate Bond Index, which is comprised of intermediate-term investment grade corporate bonds, with an overall duration of 4.5, has declined by 1.00%. The Current Income Portfolio, which is comprised of investment grade corporate bonds and preferred securities, with an overall duration of 3.4, has declined by just 0.65% gross throughout the same period. Therefore, although performance has declined year-to-date, we believe CIP has benefited more from credit spread tightening and lost less from interest rates rising than respective benchmark indices.
While we continue to believe that the “best offense is a good defense”, and that the portfolio is defensively positioned to continue to earn high current income with low overall volatility, it does not imply that we expect the portfolio to continue to decline in the future. With a credit environment that is relatively benign, coupled with solid corporate fundamentals, strong balance sheet positioning and the highest levels of interest coverage that investment grade companies have had since 2015, we expect a relatively muted effect from changes in credit spreads over the next year.
In addition, with recent improvements in the labor market, and macro-economic data seemingly showing signs of elevated inflationary pressures, FOMC forecasts now project an earlier lift-off, and greater number of interest rate hikes over next few years. Median FOMC dot plot forecasts now project three interest rate hikes in 2022, three in 2023, and eight interest rate hikes in total by 2024.
Given that a portfolio with a duration of 3.4 is most affected by the near and intermediate-term segments of the yield curve (highlighted in the white box in the chart above), and expectations for earlier, and a greater number of, interest rate hikes have been priced in (as depicted by the shift from green, to orange, to blue lines throughout 2021 in the chart above), we believe much of the projected decline from higher interest rates is already “baked into” current prices of securities in the portfolio. For further portfolio deterioration to apply, we think interest rate hikes would need to exceed what current hawkish yield curve projections imply.
The CIP portfolio continues to be defensively positioned, in our view, with respect to both credit and interest rate risk. The inclusion of fixed-to-floating rate coupons in CIP’s preferred securities allocation has helped to lower portfolio volatility from changes in interest rates. Moreover, approximately one-third of the portfolio matures in the next one to three years, which offers the opportunity to re-invest those funds at potentially higher rates. The intent to enhance yield and reduce overall portfolio risk is unchanged, and the portfolio continues to be positioned to earn high current income, without extending duration or lowering our credit quality standards.