Published on Nov. 13, 2018
Third Quarter Fixed Income Commentary
One’s investment perspective, how long market positions are likely held, is an underlying aspect of all investment strategies. Institutional bond managers, such as insurance companies and large pension funds, extend their investment perspective over many years to match against their similarly long-dated liabilities, while at the opposite extreme of the investment timeline are speculators whose investment perspective may be measured in minutes. As a result of these completely dissimilar perspectives, different reporting systems are required and deployed. The prudent speculator is forced to mark a trading portfolio daily if not even more frequently, while the institutional bond managers may not even utilize a mark-to-market system of accounting at all, and simply hold the asset-liability yield differential until maturity.
Even within the broader cohort of institutional fixed income investors, there are subgroups with striking differences in their investment philosophies. Many fixed income investors primarily seek steady and sustainable income through a variety of asset exposures; however income-oriented investors might typically hold a single asset class, investment grade bonds, in order to achieve their specific objectives. The income investor often faces a conundrum of having to balance a short-term need for regular –monthly or quarterly—income generation to meet cash flow obligations, and at the same time, the much longer-term perspectives that comes with the understanding that their income needs will extend for many years into the future, and so they need to plan accordingly.
Historical Market Review
Our Current Income Portfolio is designed with the income-oriented investor’s dual investment perspective in mind. The strategy is devised to produce the highest current income characteristics (short-term perspective) while simultaneously applying our best efforts to protect the portfolio’s principal value (longer-term perspective) in order to:
- Continue income flows over long time periods;
- Retain abilities to increase today’s income levels (longer perspective) if and when US interest rates rise.
Rising interest rate expectations (called normalization by the Federal Reserve Board policymakers) have been with all investors for a rather extended time period now. Starting at the end of 2016, the FOMC has slowly and steadily reversed the extraordinary low interest rate policies employed to stabilize the economy after the Financial Crisis of 2007-2008. The short-term interest rate target set by the Federal Reserve Board has been raised eight times, with several more on the expectation horizon. And while that may at first seem extraordinary, a historical perspective may be help evaluate where we have been and where interest rates may in fact settle.
Since the beginning of 2017, the two-year US Treasury has risen about 180 basis points, to end the third quarter yielding 2.81%. Over the same period, the 10-year US Treasury has risen only about 50 basis points, to close the third quarter yielding around 3.00%. Despite the Federal Reserve’s ongoing reversal of short-term rate policy, these market rate changes, indeed the nominal interest rates themselves, hardly seem overwhelming. In fact, the relatively anemic total rates of return for bonds over the recent past stem not from price markdowns as rates rise as much as they do from the historically tiny yields the investment grade bond market has been confined to since 2015. Still, from a historical perspective, and mindful of the Federal Reserve Board’s normalization objective, there indeed may be more upside to nominal interest rates ahead of us. The average two-year US Treasury since the 1980s has had about a 5.3% yield, and the average 10-year US Treasury yield has been about 6.7%. It’s important to note that the 80s included the hyper-inflationary era of double-digit interest rates; however no one is predicting a return to that sort of environment any time soon.
The challenge, therefore, is to determine not only how much higher “normal” rates may be from today’s levels, but of equal importance, how much time will pass before we arrive at normal. In the credit markets, especially to income-oriented investors, the latter question may actually be more important than the former.
To best meet our objective of capital preservation paired with the highest level of current income, we have most recently relied on a portfolio constructed with three distinguishing components:
- A conservative mix of investment grade corporate bonds, diversified across many industries and with a significant weighting of bonds maturing in less than three years,
- A sleeve of preferred stocks which meaningfully enhances the portfolio’s yield and income characteristics,
- Utilization of securities which initially pay coupons with attractive fixed interest rates and then either convert to floating interest rates linked to prevailing interest rates or are called at par.
To date, this portfolio structure continues to produce relatively attractive income levels with subdued price changes relative to intermediate-term corporate bonds indices which have higher interest rate sensitivity. Moreover, the fixed-to-floating rate issues have proven less price volatile than the traditional fixed rate alternatives. While it is true that longer-dated portion of the Current Income Portfolio may prove more price volatile in the short-term than the corporate bonds maturing over the next 2-3 years, the income and yield-to-maturity characteristics of the longer dated, fixed investments are dramatically higher today—and may stay so for quite a long time into the future as the market waits for Federal Reserve policy to achieve normalization.
Beyond the portfolio’s current structure, it remains an actively traded portfolio, which in this case refers to our ongoing search for incremental improvements to our portfolio’s characteristics. Through the occasional substitution and replacement of existing holdings for better alternatives, we anticipate we may have the opportunity to significantly enhance income generation. While we foresee the general three-part construction of the Current Income Portfolio remaining much the same as long as the investing environment (Fed tightening, economic growth and low inflation expectations) remains on its current path towards normalization, temporary market distortions and pricing inefficiencies will provide opportunities to improve overall portfolio yield and income characteristics. In recent weeks we have been availing ourselves of such opportunities to improve portfolio yield for our clients.