Financial Insights

Don’t Chase Yield in Fixed Income

Co-Author: Kevin E. Strauss, CFA, Partner / Portfolio Manager

If you ask a high yield bond manager, if high yield is attractive, the manager will nearly always say yes. If you ask an investment grade bond manager if investment grade is attractive, that manager will also most likely say yes. The same will hold true if you ask a preferred manager, if preferreds are compelling. The reality is the only manager who can be objective is an unconstrained fixed income manager. At ACM, we manage unconstrained portfolios, so we are able to pursue the most compelling opportunities across all debt markets. In the past few years, we have owned investment grade, high yield, preferreds, convertibles, CDs, and even TIPS, because the fixed income markets are dynamic, so flexibility is crucial. Unfortunately, most investors don’t look across all fixed-income markets, so they could end up chasing yield without sufficiently considering the interest rate and credit spread risks.

In the current environment, we think investors should keep credit risk reasonably low. Spreads are tight, so investors earn little incremental reward for taking more risk. That’s why we are focused primarily on investment grade and we have been raising the bar on quality in the past year as we continue to find attractive securities. Credit spreads are tight and interest rates are near the highest levels in 15 years; therefore, there is no need to chase yield in fixed income. Investment grade [and higher quality high yield], are significantly safer in the current high interest rate and low credit spread environment. This is because bond prices are driven by yield. As a reminder yield = (risk-free) interest rate + credit spread. When the economy struggles, risk free interest rates typically decline but credit spreads widen. In investment grade, interest rates are likely to come down more than credit spreads will widen during market sell-offs. Investment grade spreads are currently approximately 1.00%, and they don’t typically remain above 2.00% for very long during sell-offs. Therefore, if interest rates decline more than 1.00% from the current levels, then investment grade bond prices would actually rise during an economic slowdown (generating positive total return). The same cannot be said for most high yield bonds, because high yield spreads could widen significantly from current levels in an economic slowdown. As you can see by looking at the red line on the graph, high yield spreads are currently approximately 3.00%, which is near the lows of the past 15 years. They could easily widen to 5.00% or potentially higher in a sell-off as they have multiple times in the recent past. Therefore, high yield bond prices could decline meaningfully if the interest rate decline is too small to offset the potentially significant credit spread widening. Notably, the market value protection provided by investment grade bonds in the current environment should not be overlooked.

Regarding interest rates, the expectations for Fed Fund rate cuts have declined dramatically. At the beginning of the year, the market was pricing in nearly seven 0.25% cuts totaling 1.75% by January 2025, versus current expectations of less than two 0.25% cuts. ACM was skeptical earlier in 2024 of the market’s Fed cut expectations, as our CIO, Chuck Lieberman, has written multiple times. We have also stated in the past that we do not think Fixed Income managers can consistently and accurately predict interest rate movements, but rather should express an interest rate view in moderation. We have repeatedly written about the benefits of having an intermediate duration portfolio. We think both extremes of no/very low duration and very high duration do not typically make sense for most investors. We have been and remain focused primarily on bonds with a 3–7-year maturity. This keeps our exposure to the 3 and 5-year Treasury relatively high as we believe whether inflation declines gently over time or more abruptly due to an economic slowdown, yields on 3 and 5-year Treasury yields have more room to decline than the 10-year Treasury. One other benefit of a portfolio with a duration of 3.5-4.0 years is that it is not overly exposed to the risk that interest rates stay at current levels or potentially rise.

We do not think investors should think of money market funds as an alternative to a fixed income portfolio. Investing in money market or very-short dated securities exposes investors to significant reinvestment risk if/when short-term (0-3 years) interest rates decline. Based on the Fed’s March summary of economic projections, the projected Fed Funds rate to the end 2024 is 4.6%, end 2025 at 3.9%, end 2026 at 3.1%, and longer run 2.6%. This highlights that investors may be unrealistic if they expect money market rates to remain around 5%. Symmetrically, we are not encouraging investors to take significant duration risk and lock up rates for longer (we recognize this could potentially make sense for a small portion of investors). Investors often forget that long-term rates are influenced by many factors that are more challenging to predict, such as government deficits, the size of the government debt burden, long-term global growth and inflation, and the attractiveness of Treasury rates versus foreign interest rates. Predicting these factors for a decade or more is clearly difficult.

We are regularly asked by existing and potential clients about preferreds. People either ask why we own them or what we think of the ones they own. The reality is that every preferred is unique. Since they typically have no maturity or are very long-dated, buying the wrong preferred can be particularly painful. The most important nuance to understand about preferreds is that they either have fixed rate or variable/floating coupons. Variable/floating rate preferreds, which have coupons that reset (over some time period) to the interest rate environment (if not redeemed) provide protection against rising rates. Since late 2022, we have been concerned about rising rates; therefore, ACM became primarily focused on variable coupon preferreds. These securities have an interest rate that typically resets every five years to the current interest rate environment if not redeemed. People who own fixed rate preferreds have learned how painful owning long-dated, high duration assets can be. As measured by the variable preferred ETF, VRP, these securities have outperformed not only fixed rate preferreds, but also intermediate corporate investment grade bonds in 2023 and 2024.

We continue to believe fixed income is attractive with investment grade bond yields near the highest level in almost 15 years. Currently, the intermediate investment grade bond index yields more than 5.5%. These bonds provide some downside protection. Also, the duration (interest rate risk) is only approximately four years, which prevents investors from getting overly hurt if interest rates end up rising and they will benefit if/when intermediate rates (3-7 years) decline. We strongly believe fixed income investors should remain disciplined and not chase yield by taking too much credit risk or interest rate risk.

The foregoing content reflects the opinions of Advisors Capital Management, LLC and is subject to change at any time without notice. Content provided herein is for informational purposes only and should not be used or construed as investment advice or a recommendation regarding the purchase or sale of any security. There is no guarantee that the statements, opinions or forecasts provided herein will prove to be correct. Past performance may not be indicative of future results. Indices are not available for direct investment. Any investor who attempts to mimic the performance of an index would incur fees and expenses which would reduce returns. Securities investing involves risk, including the potential for loss of principal. There is no assurance that any investment plan or strategy will be successful.

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