By Rob Glownia, CFA, CFP, Riverfront Investment Group
In our 2018 Outlook, Tug of War, we wrote that the fixed income market would face several obstacles in 2018. For example, investors would have to weigh the risks of the Federal Reserve raising interest rates, the US budget deficit, and the potential for a trade war, just to name a few. With yields near multi-decade lows and the headwinds mentioned above, our strategy has been as follows:
- Continue to favor equities relative to fixed income in our balanced portfolios.
- Within our bond allocation, remain underweight high quality fixed income assets such
as US government debt, which we believe to be overvalued. - Continue to prefer corporate bonds, with the expectation that higher yields would offer
greater inflation protection and a potential cushion to absorb higher rates.
As expected, we have seen a move higher for interest rates in 2018. Specifically, the 2-year US Treasury has risen by 67 bps or basis points (bps = 1/100th of 1%) since the start of the year and the 10-year US Treasury has moved up by 69 basis points to about 3.09%. Since credit products are typically based on a spread over US Treasury rates, this has had a negative impact on almost all areas of the fixed income market.
Even though we anticipated the move higher in interest rates, we’ve been surprised at how much the investment grade corporate bond market has underperformed year to date.
Below is a table showing the returns for various fixed income sectors. As you can see, corporate bonds (US Investment Grade Corps) have been material underperformers thus far in 2018:
Source: Bloomberg. Past Performance is no indication of future results. Shown for illustrative purposes only, not indicative of RiverFront portfolio performance.
INVESTMENT GRADE CORPORATE BONDS UNDERPERFORMING FOR SEVERAL REASONS:
We believe there are a few reasons for the selloff in investment-grade corporate bonds:
Longer Duration: With interest rates being so low for the last few years, companies have restructured their balance sheets and have refinanced their debt. As part of this process, corporations have extended the maturities on their loans to take full advantage of the low cost of capital.
As such, the investment-grade segment of the market now has an effective duration of about 7 years, which is about a year longer than the bond market’s most quoted benchmark, the Bloomberg Barclays US Aggregate (duration represents a bond’s price sensitivity to changes in interest rates). For this reason, the investment grade corporate bond market has been more adversely affected than other sectors of the bond market as rates have moved higher.
Foreign Selling Pressure: As the old adage says, “money goes where it is treated best.” For a long time, that place was in the US where, despite our low interest rate environment, the income opportunity was still better than fixed income products overseas. In fact, many overseas markets have recently experienced negative interest rates! However, as US interest rates have risen, so has the cost of currency hedging for non-US investors. As a result, it has become more expensive for foreigners to own US bonds unless they’re willing to accept the currency risk associated with the US dollar exposure. For this reason, we believe foreigners who do not want US dollar exposure have been selling bonds, putting pressure on the asset class.
Weakening Credit Metrics: The size of the corporate bond market has grown substantially since 2005. With that growth, there has also been a considerable change in the composition of the sector. For example, the portion of lower quality BBB rated bonds has increased, while the quantity of A, AA, and AAA bonds has decreased. The net result is that the investment grade corporate bond market has morphed into something riskier, and investors are rationally demanding a higher level of compensation for the greater risk of default.
POSITIONING OUR PORTFOLIOS:
Despite the reasons for the selloff discussed above, we believe there are a few fundamental reasons to remain constructive on the sector.
Yield Advantage: History suggests that yield wins over time in the fixed income market. This is especially true in the investment-grade space, where defaults are nearly non-existent. Specifically, investment grade corporate bond defaults have been less than 1% going back to 1987 according to Moody’s. We believe that the additional 120 basis points in coupon income coupled with a relatively high confidence of getting your principal back (albeit with some volatility along the way) is a winning strategy.
Corporate Earnings Continue to be Strong: As of last week, more than 80% of the S&P 500 companies have reported and the Q1 earnings season has been solid. According to JP Morgan[1], 75% of companies are beating their earnings estimates, with an average positive earnings surprise of 9%. In addition to strong earnings, corporate balance sheets appear to be in good shape, with many companies having refinanced their debt at historically low interest rates.
For these reasons, we have maintained our overweight to investment grade corporate bonds, despite the underperformance YTD. The sector is now yielding more than 4%, which is the highest since 2011:
Source: Bloomberg, ICE BAML. Shown for illustrative purposes only. Past performance is no guarantee of future results. You cannot invest directly in an index.
While we’re still overweight credit, we’ve recently reduced some of our longer-dated corporate bond exposure. With longer maturities, the volatility in a bond’s credit spread (which is the premium that investors demand to compensate for default risk) is much higher. Therefore, we have substituted some US Treasury exposure on the long end of the yield curve, which we believe will help dampen volatility over the near term.
Bottom Line: Over the long term, we are strong believers in yield advantage. We are comfortable taking some shorter-term principal volatility to generate additional income, since we currently do not to expect defaults for investment grade companies.
Rob Glownia is a Fixed Income Portfolio Manager at RiverFront Investment Group, a participant in the ETF Strategist Channel.
Important Disclosure Information:
The comments above refer generally to financial markets and not RiverFront portfolios or any related performance. Past results are no guarantee of future results and no representation is made that a client will or is likely to achieve positive returns, avoid losses, or experience returns similar to those shown or experienced in the past.
Information or data shown or used in this material is for illustrative purposes only and was received from sources believed to be reliable, but accuracy is not guaranteed.
Duration is a measure of the sensitivity of the price of a fixed income investment to a change in interest rates. Duration is expressed as a number of years. Rising interest rates mean falling bond prices, while declining interest rates mean rising bond prices.
Technical analysis is based on the study of historical price movements and past trend patterns. There are no assurances that movements or trends can or will be duplicated in the future.
Investments in international and emerging markets securities include exposure to risks such as currency fluctuations, foreign taxes and regulations, and the potential for illiquid markets and political instability.
In a rising interest rate environment, the value of fixed-income securities generally declines.
High-yield securities are subject to greater risk of loss of principal and interest, including default risk, than higher-rated securities.
Stocks represent partial ownership of a corporation. If the corporation does well, its value increases, and investors share in the appreciation. However, if it goes bankrupt, or performs poorly, investors can lose their entire initial investment (i.e., the stock price can go to zero). Bonds represent a loan made by an investor to a corporation or government. As such, the investor gets a guaranteed interest rate for a specific period of time and expects to get their original investment back at the end of that time period, along with the interest earned. Investment risk is repayment of the principal (amount invested). In the event of a bankruptcy or other corporate disruption, bonds are senior to stocks. Investors should be aware of these differences prior to investing.
A basis point is a unit that is equal to 1/100th of 1%, and is used to denote the change in a financial instrument. The basis point is commonly used for calculating changes in interest rates, equity indexes and the yield of a fixed-income security. (bps = 1/100th of 1%)
RiverFront Investment Group, LLC, is an investment adviser registered with the Securities Exchange Commission under the Investment Advisers Act of 1940. The company manages a variety of portfolios utilizing stocks, bonds, and exchange-traded funds (ETFs). RiverFront also serves as sub-advisor to a series of mutual funds and ETFs. Opinions expressed are current as of the date shown and are subject to change. They are not intended as investment recommendations. Any discussion of the individual securities that comprise the portfolios is provided for informational purposes only and should not be deemed as a recommendation to buy or sell any individual security mentioned.
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Additional Index Definitions:
ICE BofAML US Corporate Index (C0A0) tracks the performance of US dollar denominated investment grade corporate debt publicly issued in the US domestic market. Qualifying securities must have an investment grade rating (based on an average of Moody’s, S&P and Fitch), at least 18 months to final maturity at the time of issuance, at least one year remaining term to final maturity as of the rebalancing date, a fixed coupon schedule and a minimum amount outstanding of $250 million.
Bloomberg Barclays US Aggregate Bond Index measures the performance of the US investment grade bond market. The index invests in a wide spectrum of public, investment-grade, taxable, fixed income securities in the United States – including government, corporate, and international dollar-denominated bonds, as well as mortgage-backed and asset-backed securities, all with maturities of more than one year.
It is not possible to invest directly in an index.
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[1] JP Morgan Earnings and Options Volatility Monitor, week of May 7, 2018.