Published on Jan. 24, 2019
Fourth Quarter 2018 | Fixed Income Commentary
The final months of 2018 will likely be remembered across U. S. capital markets for extreme levels of daily price volatility. In fixed income, final year-to-date performance was for most bondholders generally lackluster and uninspired. What slight differences there were between the various market sectors can generally be explained by a simple and straightforward metric-credit quality. Counterintuitively, high returns were achieved in instruments thought to be safer, and low total returns (indeed negative for the year) were provided by investments thought to be more risky. One-to-ten year U. S. Treasury and agency bonds saw annual total returns of about 1.44%; one-to-ten year AA-rated corporate bonds gained around 1.23%; one-to-ten year A-rated corporate bonds gained about 0.14%; and one-to-ten year BBB-rated corporate bonds put in a slightly negative (0.68%) total return. Below investment-grade returns were even more negative.
Caught in the malaise, preferred stocks suffered through one of that group’s worst quarterly performances since the Credit Crisis of 2007-09, most notably with the final three months dragging the sector down to its first negative annual return since 2013. Specifically, the ICE Bank of America Merrill Lynch Fixed Rate Preferred Securities index, after posting a respectable first half, ended the year down around -4.34%, as a result of the dismal fourth quarter’s -4.56% total return. This abrupt shift in performance was tied to a near-perfect storm of short-lived technical factors which were eventually overwhelmed by quickly changing fundamental realities. Technical forces of supply and demand were felt most acutely by the largest exchange-traded funds, but prices were hit across the entire preferred stock universe.
Over the first half of 2018, prices of $25 par preferred stocks benefitted from two key positive supply and demand factors. Inflows into the sector’s ETFs ran noticeably higher than usual mid-year as investors continued a long-term hunt for yield. This prolonged demand coincided with an abundance of higher fixed rate coupon issues being redeemed by corporate treasurers. Preferred stock prices were therefore generally supported by growing demand and dwindling supply—and just as significantly, this took place even as most investors were expecting the Fed to continue to steadily raise short-term U. S. interest rates.
In early October 2018 after Fed Chair Powell said that the Fed was far from done with rate hikes, capital markets responded and investors began adopting a more cautious stance with respect to both stocks and bonds. This took place in the backdrop of increasing trade tensions with China and some signs of weakness in overseas economies. Prices of both stocks and bonds immediately began to discount further interest rate hikes and the ten-year Treasury yield jumped from about 2.81% to almost 3.23% from late August to early October. Prices of fixed rate credit instruments, especially perpetual maturity issues like traditional $25 preferred stocks, are sensitive to this kind of rising interest rate environment and bearish price outlook. A host of additional negative economic events, including falling oil prices, geopolitical uncertainties, and domestic political upheaval, culminating with the Democratic Party’s gains and control of the House of Representatives after the midterm elections, quickly compounded the long-standing complacency which had characterized the fixed income market.
The result appeared to be a significant “flight to quality” by investors, causing the stock market to decline, a widening of investment and non-investment grade credit spreads, and significant preferred stock ETF outflows. All of these factors combined pushed the ten-year Treasury yield back to 2.62% as investors sought out the safe haven of government bonds, while simultaneously depressing the market prices of most fixed and fixed-to-floating rate preferred stocks and reversing the favorable technical trends of earlier in the year.
Performance and Outlook
The Current Income Portfolio remained fully invested throughout 2018 in the investment grade U. S. credit markets, generating current yields generally between 4.50-5.0%. While the fourth quarter brought higher volatility than we expected, our allocation to good quality intermediate-term corporate bonds, $25 par preferred stocks and $1000 fixed-to-floating rate preferred stocks helped stabilize the portfolio and mitigate price declines relative to the intermediate-term bond index. The corporate bond component of the portfolio was constructed to provide price sensitivity (as measured by duration) considerably less than intermediate corporate bond indices. This strategic decision also helped to buffer the portfolio from the fourth quarter’s volatility.
Our decision to incrementally upgrade some of the portfolio’s corporate bonds to A-rated from BBB-rated bonds during the year also helped minimize the fourth quarter price volatility. In addition, our decision to shift the preferred allocation of the portfolio to both higher coupon issues as well as fixed-to-floating rate issues also helped performance of the portfolio. Lastly, incrementally shifting the portfolio’s preferred allocation toward $1000 par preferred stock issues also generally helped stabilize the portfolio while at the same time providing significantly enhanced levels of current income compared to what is typically offered in the investment grade credit space.
By mid-January 2019 as we conclude this letter, market prices in the preferred stock market have already recovered much of their exaggerated year-end decline. The underlying question we are left with as fixed income investors after the closing months of 2018: does credit quality deterioration, investment grade credit spread widening, anxiety over monetary policy, and a flight-to-quality revival continue, or were the final weeks of the year instead an opportunity for productive portfolio repositioning? Holding true to our investment objectives, we believe that enhancing current income as opportunities present themselves remains the most reliable way to maximize longer-term wealth creation. Rather than speculate on the credit market nuances ahead, we prefer to conserve as much principal as possible while maximizing the current income improvements available for the clear and present taking. Our approach is to remain focused on annual expected cash flows, and so we tend to welcome (not fear) wider credit spreads as we welcome (not fear) higher ( “normal” if you prefer) nominal interest rates.