Published on July 25th, 2022
Second Quarter 2022 | Fixed Income Commentary
In the first half of 2022, fixed income markets experienced surprisingly large declines. Initially, concerns over elevated inflationary pressures and geopolitical events triggered expectations for higher interest rates, which weighed on fixed income valuations with longer durations. During the second quarter, credit concerns also began to surface as it became clear to us, that even tighter monetary policy would be necessary to tame the surging (and broadening) levels of inflation, even at the cost of potentially slowing down the economy.
Roosevelt’s Current Income Portfolio (CIP) declined 3.1% gross and 3.2% net, in the second quarter, taking the first half performance to a decline of 7.2% gross and 7.6% net. The Bloomberg Intermediate US Corporate Bond Index (comprised of 1-10 year maturity investment grade bonds) declined 3.9% and 9.0% in the second quarter and year-to-date, respectively and the ICE BofA Preferred Securities Index, P0P1, (comprised of 40% institutional and 60% retail preferred securities) declined 7.7% and 13.9% in the second quarter and year-to-date, respectively.
Throughout the quarter, the Consumer Price Index and Personal Consumption Expenditures Index increased to some of the highest levels in the past 40 years1
, and the Federal Reserve hiked interest rates by 50 bps and 75 bps in April and June, respectively, and signaling the need for the Federal Reserve to possibly hike more times this year. Moreover, in a statement made to Congress in June, Federal Reserve Chair Powell vowed that the committee’s commitment towards fighting inflation was “unconditional” and that price stability would be prioritized over both employment and growth.2
Accordingly, the market implied Fed Funds Rate in December 2022 increased to 3.4%, up from just 0.8% at the start of the year3
, as markets reacted to the more hawkish outlook by the Federal Reserve. We believe expectations for the FOMC to hike interest rates higher and faster than previously expected not only caused the yield curve to move higher, however, but also increased the possibility of an economic slowdown or even a recession. As a result, credit spreads widened across the quality spectrum to reflect the growing levels of uncertainty.
Higher yields and wider credit spreads appear to have had the greatest impact on fixed income securities having longer durations and lower quality credit ratings. As such, the Intermediate Corporate Bond Index and the ICE BofA Preferred Securities Index underperformed CIP due to their longer durations, and greater spread durations, which indicate to us greater price sensitivities to changes in interest rates and credit spreads. Due to the sharp selloff in fixed income markets year-to-date, Roosevelt is now buying securities at considerably higher yields than at the start of the year. The average yield to worst on the US Corporate Bond Index reached over 5% for the first time since 2009 and we are now able to re-invest proceeds from maturing securities at average yields to worst of 4.8%.
With respect to the credit quality of the portfolio, we believe the investment grade securities in the portfolio have a solid footing heading into a potential recessionary environment. At present, companies rated BBB- or better generally have some of the highest levels of interest coverage, and lowest levels of net leverage, that the group has had in recent years. In addition, investment grade companies tend to be larger, and more diversified in terms of their business segments, putting them in a better position to withstand potential cost pressures and/or declining profit margins in a recession. Furthermore, many companies have “termed out” their debt in recent years by calling securities early and re-issuing them at lower costs and longer maturities, effectively reducing the chances of facing pressures from near-term funding needs. Therefore, based on the current interest rate environment and our view of the resiliency of high-quality corporate issuers, we believe investing in corporate bond and preferred securities provides an attractive risk/reward today.
Over the past year the portfolio management team has sought to defensively position CIP for a volatile interest rate environment and the potential for wider credit spreads, generally tilting the portfolio towards lower duration and more recently, higher quality securities. While we continue to favor a mix of both fixed and fixed to floating rate coupon securities, given the increased chances of a recession we have taken additional steps to slightly upgrade credit quality in the portfolio. In addition, with the market now discounting a greater likelihood of rate cuts in 2023, we believe the portfolio’s very short duration may no longer be optimal. We aim to take a balanced approach in seeking high current income without taking on excess credit risk or making interest rate bets in either direction. As always, we continue to monitor geopolitical events and the macroeconomic environment as we seek attractive levels of income and capitalize on the opportunity to invest in higher yields.
Performance Summary as of 6/30/2022
As of June 30, 2022