Monthly Global Market Commentary February 19, 2018

Fixed Income Strategies for a Volatile Rate Environment – By Bryan Dooley, CFA

America’s ballooning budget deficit, the winding down of central bank bond purchases and a recent whiff of inflation have conspired to push interest rates higher. Global bonds markets were relatively well behaved last year as rates marked time within a narrow trading band. But this year, longer term yields spiked, causing a sharp selloff in bond prices which then spilled over into equities earlier this month. Since the end of last year, the ten-year U.S. Treasury yield has jumped 47 basis points to approximately 2.87% as of this writing, the highest level in over four years.

Rising interest rates historically have caused volatility in the risk markets as some investors are encouraged to sell stocks in favor of bonds with better yields. Since the beginning of the Great Recession nine years ago, central banks around the world have imposed ultra-low interest rates which provided almost no competition for stocks and other riskier assets. But this year’s rate pop seems to have suddenly created a shift. February’s price action occurred swiftly and dramatically, hurting both stock and bond prices at the same time and that has caused some investors to re think their strategies.

While higher rates may be good for bond investors in the long run, the immediate effects on outstanding bond prices can be problematic. Bond yields and prices move in opposite directions as existing bonds have lesser value when prevailing rates of interest go higher. For example, an owner of a ten-year bond paying two percent, when the market rate rises to three percent, now has a less valuable piece of paper. Because of this year’s increase in yields, the widely-follow Barclays Aggregate bond index has fallen about 2.12% year-to-date.

While rising rates present some challenges, investors should not necessarily abandon fixed income as an asset class. For one thing, stock market volatility is on the rise and most investors can use the risk hedge normally offered by high grade bonds. Indeed, fixed income has historically acted as a stabilizing factor during difficult markets. But if rising rates are beginning to impact both stocks and bonds, how does one create a safety net?

The answer lies in having an active fixed income management strategy. While so-called “passive investing”, or simply cloning a prescribed index, has gained popularity in the equities space, many experts are skeptical of its effectiveness in the fixed income arena. I certainly agree that active management is the best approach over the long run, but is even more important in the current environment.

Despite the upward pressure on interest rates and downward pressure on bond prices, a few strategies make sense for this point in the interest rate cycle. Using a laddered maturity approach and investing in floating-rate notes, callable bonds and select asset- backed securities affords investors some protection against rising rates. Employing the right tactics may even provide an opportunity to profit from a more volatile interest rate environment.

A laddered portfolio consists of bonds which mature in successive years. Longer maturities typically pay a higher rate of interest than shorter term bonds. Therefore, an investor owning a bond portfolio laddered out to five years will not only benefit from the higher rates farther out the interest rate curve, but will also have bonds coming due each year. As those bonds mature, they can be reinvested at progressively higher rates of interest, assuming yields continue to rise. Conversely, if rates fall for whatever reason, at least a portion of the portfolio has been locked in at the more advantageous levels. A bond ladder is the most basic rate-hedging strategy, but other vehicles such as floating rate notes are also available.

Floating rate notes have coupons which are automatically adjusted at regular intervals, usually quarterly at a predefined level above the London Interbank Offered Rate (LIBOR). Three-month LIBOR, presently hovering around 1.88%, has increased significantly since its lows of around 0.25% seen just a few years ago. Floating rate note owners have thus benefitted from a steady rise in their income payouts as short-term rates continue to climb. Investment grade floaters typically pay a spread above LIBOR between 0.25% to 1.00% depending upon the final maturity date and the credit quality of the issuer.

Another structure we like in this environment are premium bonds trading to short term call dates. For example, an insurance issue we like has a 7.875% coupon with a long-dated final maturity, but is callable in November of this year. If the bond is called, investors will receive a yield-to-call of about 2.5%. This yield represents a premium above a comparable Treasury, or “credit spread” of 180 basis points. Rates seem to be going higher but likely will not be high enough to make it worthwhile for the issuer to pass on the opportunity to call this bond. The issuer will almost certainly refinance such a high coupon as soon as they are legally allowed. For this reason, the bond should continue to trade as a short-term bond (meaning less volatile) even though the final maturity is much farther out. If, however, the bond is not called, the total realized yield only gets better as the owner will earn the higher coupon for a longer period of time.

Another interesting tactic for this environment is investing in shorter term securities with higher credit spreads. Unfortunately, however, the game has become substantially more challenging in the traditional corporate bond market as spreads have ground much tighter over the past year. In fact, current corporate bond spreads are trading at historically tight levels, offering little upside and the possibility of lower prices if the credit environment begins to deteriorate for any reason.

On the other hand, a few subsectors of the asset-backed securities (ABS) market have not seen the same degree of tightening. We frequently see securities in this category offered at fairly attractive yields and spreads. Moreover, many of these securities have floating rate features which provide protection against further interest rate volatility.

Investing in ABS securities requires rigorous analysis and access to the right research tools. For example, we have recently seen some excellent commercial mortgage-backed securities (CMBS) on offer, but it is important to know that not all ABS is created equal! CMBS issues backed by shopping malls are under credit pressure as traditional brick and mortar retailers struggle to keep up with the growth in online shopping.

Change provides both risks and opportunities. Having an active fixed income manager who understands the fast-moving components of today’s bond market may be the key to surviving and even thriving in today’s markets.

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The information contained in this article is for information purposes only, and represent the views of the author. It is not intended as specific investment or financial advice, or a recommendation or solicitation to buy or sell any security. Any investments or strategies listed in this article may not be suitable for all investors. Past performance is not indicative of future performance, and as with any investment, prices may fluctuate. It is recommended that advice is sought from a qualified investment professional prior to implementing any financial plan. LOM has made every effort to ensure that the contents herein have been compiled from sources believed reliable, however LOM does not warrant the accuracy, adequacy, timeliness, or completeness of this information expressly disclaims liability for errors or omissions in this information.