Fixed income yields approximately 5%, hopefully you own some
by Kevin Kelly and Kevin Strauss, CFA, Fixed Income Portfolio Managers
A relatively low duration, investment grade corporate portfolio yields approximately 5% (including municipals tax-adjusted for the highest tax brackets). Investors can lock up this attractive yield for approximately three to four years. If interest rates go down, investors will earn the yield as well as price appreciation (total return). If rates go up moderately, the 5% yield will more than offset the potential negative price impacts from Treasury rate increases. If rates were to rise substantially, then investors can just hold their bonds until maturity/redemption. We think investors should review their asset allocation to ensure they are taking advantage of the currently attractive fixed income environment.
Fixed income markets have not been immune from the recent volatility in the global banking industry. Interest rates have fallen significantly in recent weeks as investors seek the safety of owning Treasury bonds. As expected during volatile times, credit spreads have widened as investors prefer safe havens. Investment grade spreads have widened by approximately 0.25% while high yield spreads have widened by more than 1.0%. Preferred prices have also fallen as a large portion of preferred issuers are financial companies. In uncertain times, the selling is generally indiscriminate. Even the preferred stocks of some of the largest U.S. banks that are classified as systemically important financial institutions have traded lower. We think eventually calmer minds will prevail.
Last week, the Fed raised its key policy rate by 0.25% and continued its hawkish tone because reducing inflation remains a necessity, not an option. However, the Fed seems to prefer a patient approach given how many recent hikes have occurred and the recent banking concerns. While unemployment remains low and wage growth somewhat elevated, the Fed recognizes that the potential credit tightening due to banking and liquidity concerns may have a tempering effect on the economy similar to that of additional interest rates hikes. The Fed’s key policy tool, the overnight Fed Funds rates, is an extremely blunt instrument that works with long and variable lags. Even the Fed recognizes that more rate hikes may not be the ideal or most effective solution to reducing inflation. We expect the Fed will remain extremely data dependent for the rest of 2023. However, for what it’s worth, the Fed’s summary of economic projections include one more 0.25% increase by year-end. The markets feel very differently and currently predict the Fed Funds rate to decline approximately 1% from the current level.
We think it is worth clarifying to investors that most public companies that issue bonds and preferred stocks are not primarily dependent on getting a loan from a bank for capital. Companies have banking relationships, but large companies are not asking the bank for a loan every time they want to invest or buy something. Therefore, the potential credit tightening Chairman Fed Powell discussed would have a much larger effect on smaller companies than companies large enough to issue public bonds or preferred stocks. This is notable because yields on investment grade corporate bonds have declined recently since interest rates have fallen more than credit spreads have widened. The same cannot be said for high yield securities, however, as these are more sensitive to volatility and economic uncertainty. The cost of debt for high yield companies has increased, but the differentiation of issuers in high yield is quite substantial. Better credits will likely be able to issue bonds at yields relatively similar to those preceding the recent volatility, while weaker companies will have to really pay up to attract interest. As we saw this week, the corporate bond market is still open for high quality companies looking to issue debt.
Fixed income remains attractive with investment grade corporate portfolios offering a 5% yield per annum (including municipals tax-adjusted for the highest tax brackets), assuming no sales or credit issues. In a low growth environment, 5% per annum is very attractive. Even in an economically difficult scenario, investment grade bond portfolios could perform reasonably well since interest rates would likely decline more than credit spreads would widen. (Reminder: yield = interest rate + credit spread) Therefore, yields would be lower and consequently bond prices higher, in addition to the attractive yield earned from just holding the securities. ACM’s approach to fixed income strategy remains primarily focused on preservation of capital with the long-term goal of generating income in excess of inflation. We continue to actively monitor our portfolios and evaluate new opportunities, and we will remain disciplined and vigilant.
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