We have been spoiled by the long bull market in U.S. Treasuries, which has driven interest rates lower and facilitated outsized gains in equities and other risk assets. At some point, the party will end and rates will move higher. Advisors must understand the inherent risks, and proactively evaluate alternatives for their fixed income portfolios to manage through successfully.
Rising interest rates can wreak havoc on a client’s fixed income portfolios. Do not be lulled into complacency as the wave of persistently declining rates has allowed any long-only fixed income fund – the blander the better – to generate enviable returns over the last several years.
In fact, the risk inherent in portfolios indexed to the Bloomberg Barclays Aggregate Fixed Income Index (the “AGG”) and the US Investment Grade Bond Index (“IG”) are at the highest level in recent memory. The duration of the AGG is 6, and the IG Index is 8.7. A simple mathematical example of a 1% rise in the 10-year Treasury would cause an approximately 6% decline in the AGG and an 8.7% decline in the IG Index, all things equal. This would be a shocking outcome for people who perceive these asset classes to be low-risk. Ordinarily, IG spreads would tighten to partially compensate for the move higher in rates, but spreads are so compressed already, it seems hard to imagine they can go much tighter from here.
Some investors have taken notice and begun to make changes. One of the popular trades has been selling fixed rate debt (IG or High Yield) and buying leveraged loans or funds that invest in such loans. The logic is that loans are floating rate products rather than fixed, and also that because loans were out-of-favor while rates were trending lower, that they are cheaper on a relative-value basis.
Inflows into bank loan funds so far in 2021 are $2.7 billion, or 3% of AUM in the asset class, which is on track for the highest amount since May 2018. New CLO formation in January, according to CSFB, has already been $5.3 billion from 11 deals, a sharp increase over 2020’s $1.95 billion across only 4 deals.
When the loan market sees large inflows, borrowers take advantage and re-price their loans lower, limiting future yields. Unlike loans which typically offer little or no call protection, fixed rate High Yield bonds would benefit from an anticipated rise in rates as companies would look to lock-in lower rates and would have to pay call premiums to refinance. Due to the increasing prevalence of loan-only capital structures, the amount of leverage through these loans is higher.
Covenant trends have also weakened, as evidenced by the Moody’s Loan Covenant Quality Indicator hitting a record low in Q2 2020, and barely budging in Q3. These trends signal rising default risk and lower recovery rates on the loans that end up defaulting. While some exposure to leveraged loans might make sense, buying loans primarily for the floating rate feature is akin to overpaying for an expensive sports car because you like the steering, regardless of whether the value of the car is sensible.
It is important to understand what would be the driver of higher interest rates, including improving economic activity, tightening labor markets, and increasing inflation expectations. The Federal Reserve has indicated that their employment target for starting to tighten (the Non-Accelerating Inflation Rate of Unemployment or “NAIRU”) is different than prior cycles. Not only does the Fed want to see full employment, they also want minority unemployment rates near their all-time lows, real wage growth, and a narrowing income gap – all noble societal goals. However, even if the actual Fed tightening comes later or if the Fed lets the labor market tighten further than in prior cycles, market participants might begin to fear that the economy will eventually overshoot.
While the pace of economic recovery is likely to be choppy and uncertain, rather than a straight line, I do believe that as more people become vaccinated and society is able to reopen, there will be a massive wave of animal spirits unleashed. As people have been hunkered-down, unable to travel, unable to move freely, we have coincidentally seen an incredible rise in the savings rate on account of stimulus, a wealth effect from the phenomenal returns in the equity markets, and an actual inability to spend some of those dollars.
There will be immense desire to travel, make large purchases, attend live concerts and theater, eat out at restaurants, and all of the other enjoyable things in life to which people have been deprived. However, there will be a scarcity of available airplane seats, hotel rooms, restaurants, and concert tickets. It will take time and money to return aircraft parked in the desert to active service, many hotels and restaurants have closed permanently during the pandemic, and they haven’t found a way to clone rock stars (yet). Retailers have closed stores, and learned how to operate with much leaner inventory levels. Supply chains have been strained during the pandemic, and won’t easily be able to ramp up capacity. This shortage of supply coupled with a surge in demand might create a short-squeeze type phenomenon across the economy and push up prices.
Understanding that an improving economy will be the driver of higher rates, look for strategies that can play defense during such periods, or even thrive and generate compelling total returns. Hedging the interest rate risk in a corporate credit focused portfolio would allow credit risk to shine through in a time where the improving economy lessens credit risk and drives high yield spreads tighter.
The anticipation of higher rates may also spur companies to refinance as much of their debt as possible and drive high yield bond prices up as they get called, while their bank loan counterparts would re-price into lower yielding paper for no compensation.
Furthermore, consider the municipal bond asset class, which exhibits favorable attributes during periods of rising rates, especially if the strategy hedges interest rates. Because of its large retail investor base, which tends to be more buy and hold, prices are generally more stable relative to Treasuries.
Higher expected income tax rates should also provide additional demand for tax-exempt municipal bonds, at a time when rising rates typically reduces new-issuance supply, creating favorable supply/demand technicals. Combining some of these strategies can help prepare your clients’portfolios for the possibility of rising interest rates by limiting interest rate risk while taking advantage of an improving economy.
Jeff Rosenkranz is a fixed income portfolio manager for Shelton Capital Management
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