The 3 Main Ingredients for Fixed Income Success
Co-authored by Kevin Strauss, CFA, Partner / Portfolio Manager
Many investors pay little attention to their fixed income holdings, although the past few years have highlighted that this can prove costly. Furthermore, while we recognize that fixed income can’t compete with the latest hot AI or tech stock for your attention, a yield in excess of 5% on a quality fixed income portfolio should not be ignored. We strongly believe that the three essential ingredients for fixed income success are active management, owning individual securities, and ensuring that the duration of the portfolio reflects the current market environment.
Active Management
Active management allows investors to better select duration and credit quality/mix as market conditions change. While we do not pretend to anticipate all market movements, we firmly believe that astute portfolio managers can monitor economic data and adjust portfolio holdings accordingly. Many fixed income investors simply buy brand name bonds (issuers that every retail investor knows) and then hold those until maturity without evaluating other options. We think clients deserve better.
Active management also allows investors to remain opportunistic. The past three years have each presented opportunities for active management to create value. In 2021, we sold many bonds with maturities of more than 3 years that had yields of around 1%. At the same time, many funds bought intermediate and long-dated bonds yielding less than 2% because either they were forced to by their mandate or they believed long-term rates would remain low. Those bond holdings proved disastrous by 2022 as interest rates rose. We focused on managing our duration risk without taking our duration to an extreme low. Similarly, in the preferred market, we significantly reduced fixed rate preferred exposure in favor of variable/floating rate preferred stock, which have coupons that reset to the interest rate environment (if not redeemed) and so provide protection against rising rates. Even more opportunistically, we purchased treasury inflation protected securities (TIPS), which benefit from rising inflation. In 2023, we remained disciplined by not chasing duration (and adding to interest rate risk) every time rates declined. On the offensive side, the regional banking crisis created opportunities as securities from even the highest quality financials sold off dramatically. Furthermore, CDs were getting issued at higher yields than Treasuries, which made them more attractive, since both assets are government guaranteed.
Owning Individual Bonds
The benefit of owning individual securities cannot be overstated. Owning individual securities in an unconstrained strategy allows investors to take advantage of opportunities the market offers and does not force the sale of attractive securities that no longer meet the narrow criteria of a specific fund/ETF. For example, many funds/ETFs own exclusively bonds or preferreds or converts. Additionally, funds/ETFs are often constrained to be either all investment grade or all high yield with no flexibility to adjust to market conditions. An unconstrained account, by contrast, can own all, some, or none of each of these types of securities at any point in time based upon on market opportunities. For example, if a fund may own only investment grade bonds with a maturity of 1-5 years by its mandate, it must sell these holdings if they get downgraded to high yield or as the maturity drops to less than a year. Such forced sales are not always logical or beneficial to the client.
Individual bonds also give investors their own cost basis on a security should they want to tax loss harvest. In addition, an investor avoids adverse impacts on a fund/ETF’s net asset value from liquidity risk that can be triggered by abrupt redemptions.
Thoughtful Duration
The third ingredient to fixed income success is ensuring the duration of a portfolio reflects the current environment. We think it is important that portfolios don’t get too short or too long with their duration. In the current environment, we think an intermediate duration is the appropriate balance between risk and return. We think investors should want to lock in current interest rates for some period of time without going too far and taking significant duration (interest rate) and credit spread risk. It is worth noting that not all 4-year duration portfolios are created equal. We are purposefully focused on 3–7-year bonds as opposed to a mix of 1–10-year bonds. We think the 3- and 5-year Treasury yields have more downside than the 10-year when either inflation or the economy slows. Since the yield curve is currently inverted, just the curve normalizing will lead to the 3- and 5-year Treasury declining more than the 10-year.
While we recognize that many people are still hiding out in money market funds, a very short duration selection, we do not think this is ideal at this point in the rate cycle. Whether the market’s expectations or the Fed’s Summary of Economic Projections proves correct, 5% money market yields are likely to end at some point in 2024. We recognize some people are using money markets as an alternative to leaving money in the bank at a much lower interest rate, and this is understandable. However, we do not think investors should think of money market funds as an alternative to a fixed income portfolio. As a reminder, the Fed’s December 13, 2023 Summary of Economic Projections indicates that the Fed Funds rate will decline by approximately 0.75% by the end of 2024 and another 1.00% in 2025. This implies a money market rate of approximately 3.25% at the end of 2025. If investors have set duration too short, they will face unattractive rates when it’s time to reinvest those funds. The Fed will come out with projections again this week, but it is extremely unlikely they will predict a 5% money market yield a few years from now. Some investors feel that they have timed rates successfully thus far, but we remind them that when interest rates do move, they can move very quickly. In 2023, intermediate corporate bonds returned more than 7% with nearly all of this return coming in the fourth quarter.
So while it is a risk to set duration too short, we are not advocating locking in rates for 10-20 years either. Buying long-term bonds exposes investors to 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 nearly impossible.
The reality is that one size does not fit all clients or environments in fixed income. Moreover, conditions change and portfolios need to adapt accordingly. This is why active management is crucial. Owning individual securities within an unconstrained strategy is a key component of ensuring active management is as flexible as possible. We continue to view a yield in excess of 5% on intermediate corporate bonds as compelling in the current moderate inflation and growth environment.
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