Published on Apr. 26, 2019
Current Income Portfolio – First Quarter Commentary
The beginning of 2019 saw a reversal of the credit market themes that dominated the closing months of 2018. With the exceptions of U. S. Government and very high-grade corporate issues, most of the domestic credit markets suffered pricing declines in response to what we believe was widespread anxiety over continuing monetary policy tightening, possible credit quality deterioration, investment grade yield spread widening and geopolitical uncertainties. These factors appear to have combined and led to a classic ‘flight-to-quality’ environment of uneasiness, particularly in December.
In January, however, and continuing on over the rest of the first quarter, these concerns seem to have abated and both bond and equity market conditions improved, helped in part we believe by a newfound dovishness on the part of the Fed, as well as some evidence of macroeconomic improvement and hints that perhaps a resolution to the China trade was might be possible.
While the ten-year U.S. Treasury was relatively stable, trading around a twenty basis point range, other investment grade credit markets were more volatile. Specifically, the spread widening observed in the corporate bond market, which had occupied much of the business press late last year, fell back comfortably into historically tight ranges. The yield spread of investment grade corporate issues rated single A fell about 21%, from 1.20% at the close of 2019 to about 0.95% at quarter end. Likewise the yield spread of investment grade corporate issues rated BBB fell about 19%, from around 1.90% at the close of last year to about 1.58% at quarter end. Spreads for both types of issuers are now approximately in line with where their historic averages since 2014.
Similarly, the preferred securities market which in the fourth quarter suffered through one of the most disappointing performance quarters in terms of total rate of return in our recent memory, reversed and rallied back sharply in the first quarter. The ICE BofAML Fixed Rate Preferred Index posted an 8.71% total return for the first quarter of 2019, following the previous quarter’s 4.56% negative total return. And the ICE BofAML Capital Securities Index, which specifically tracks the $1000 par preferred security issues, posted a 6.43% total return for the first calendar quarter, following the previous quarter’s 2.55% negative total return. In both cases, the combined two-quarter total returns averaged about 4.0%, historically slightly higher than recent experience would suggest.
The intermediate-term investment grade corporate bond market, benefitting from the return of yield spreads to historical norms, also posted relatively strong quarterly total returns. The ICE BofAML 1-10 Year US Corporate Index had a first quarter total return of about 3.80%, following a Q4 2018 total return of about 0.61%. This performance was significantly stronger than the ICE BofAML 1-10 YEAR US Treasury Index which posted a 1.57% first quarter return, following the previous quarter’s 2.20% total return. Over the last two quarters, we believe that the intermediate corporate market has benefitted significantly from slightly lower U. S. nominal interest rates and tighter investment grade yield spreads.
To cap things off, the Federal Reserve Board policymakers announced delays in future monetary policy adjustments. In combination with reversals of credit spreads and a beneficial re-pricing of the risks of holding preferred securities, the slightly negative returns for Current Income Portfolio accounts in 2018 were more than clawed back with a nearly 4.4% total return in the first quarter. This compares favorably with the 1–10 year investment grade corporate market which posted a return of 3.8% as well as the broad Intermediate Government/Credit benchmark total rate of return of 2.32% over the same period.
We believe the advantages of the building our Current Income Portfolio accounts around a balance of intermediate-term investment grade bonds and preferred securities is demonstrated by the style’s performance over the ups and downs of the rather volatile past six months. We believe that underlying these accounts is a steady income characteristic that has remained undisturbed through periods of market volatility, both higher and lower.
New accounts are presently funded at about 4.52% current yield, which is above the level of the product’s stated benchmark as well as the intermediate-term corporate market. Moreover, our incorporation of investment grade preferred securities tends to elevate the style’s overall current income and yield characteristics, but does so in a limited and identifiable manner. To this point, while the portfolio’s yield matrices are higher than alternative investment grade fixed income offerings, especially mass market alternatives such as full market mutual funds and ETFs, interest rate risk assumed by the Current Income Portfolio is currently lower (as measured by modified duration). New accounts presently feature a corporate bond duration of about 4.08 compared to the intermediate benchmark’s approximate 4.16, and this duration may be allowed to decline over the remainder of 2019 as portfolio holdings get closer to maturity and thus shorten in term.
By remaining loyal to our objectives of seeking to provide the highest possible returns while assuming the least possible risks, we have sought to take advantage of the market’s recent pricing volatility. Discounted prices in the preferred securities markets offer the opportunity to slightly increase our allocation in this sector. While we would have preferred higher nominal rates, most long-standing accounts are able to benefit from the Current Income Portfolio’s design which provides for regular reinvestment of bond holdings in the corporate sleeve as they mature or are called. The use of perpetual, fixed rate preferred securities, which remain potentially price sensitive to general interest rate rises, does not, at this point, dramatically increase the portfolio’s overall interest sensitivity. Higher coupon fixed rate issues and positions in fixed-to-floating rate preferred issues tend to reduce the overall portfolio duration. While we believe that the option for issuers to call their preferred securities at par after a designated date adds an element of risk to these holdings, we believe it is a risk that investors are compensated for through the higher yields on these securities. This structural characteristic may at times also provide an anchor to keep prices trending toward par values as cycles progress, therefore perhaps helping to both dampen the volatility of and enhance the attractiveness of investing in, these issues.
To us, guessing the future direction of interest rates remains a fool’s errand. Our expectations of when monetary policy may next effect nominal interest rates, either by resuming tightening credit conditions (raising short-term interest rates), or by beginning to ease credit market conditions (lowering nominal interest rates) are just an educated guess—and we and the markets at-large have been wrong as often as not. We believe therefore that the most productive approach to safely generating higher income is to identify and execute the sector allocations and positions that we believe currently will produce the highest levels of current income available while assuming the lowest levels of risks to achieve our underlying goals of principal preservation, without expressing a strong view on the future direction of rates.