I’ve been spending a significant amount of time over the past several weeks pondering the following:
- Which of the two interest rate scenarios do I think are most likely to play out over the coming months:
- A ‘benign’ Federal Reserve with gradually rising interest rates along the curve over an extended period? A ‘slow walk’ higher in a leisurely, controlled fashion? Interest rates rising gradually on the short end of the yield curve and long term rates remaining stable resulting in a flattening of the yield curve.
- A rapid rise in the yield curve with long rates moving higher as rapidly or more rapidly than the short end of the curve as the Federal Reserve raises short term rates.
- The effect that the Federal Reserve’s rate hikes and monetary tightening will have on stocks, real estate, commodities, and other asset classes.
The conclusion that I’m reaching, which appears beginning to be confirmed by recent market volatility, is that the Federal Reserve will overshoot in terms of rate hikes, sparking a yield-based ‘wildfire’. The story plays out like this:
- The Fed raises short term rates at their expected pace. Investors who have purchased long maturity bonds begin to realize that their long term bonds contain a tremendous amount of downside risk. Remember that many investors have not experienced a 1% increase in interest rates in years. For a portfolio of 30 year U.S. Treasury bonds, this 1% increase will result in a market price drop of about 17%.[i] For a portfolio of 10-year U.S. Treasury notes, a 1% increase in interest rates will result in a portfolio decline of approximately 6.4%.[ii]
- As investors begin to realize the magnitude of these rate increases, they rush to the exits to sell their bonds. The problem is that the exits are narrow and the more they try to squeeze through, the fewer buyers there are on the other side of the door, resulting in an even more pronounced decline in bond prices. This will cause rates all along the yield curve to spike higher, resulting in additional waves of selling.
- As bond investors begin to panic, stock investors, fearing a slowdown in corporate earnings, jump ship, resulting in higher stock market volatility. We really don’t know the extent to which derivatives that effectively short the market have on stocks, but we do know that they appear to have increased equity market volatility. Of course, interest rate sensitive stocks, those with high leverage or dependent upon big borrowing programs, like utilities, for example, or real estate, will probably underperform broader market averages because their cost of funds is moving higher, resulting in lower earnings.
Our tactical strategy is going to be to first protect the fixed income allocations by lowering portfolio duration and finding better investment vehicles to weather this storm and then to take advantage of some of the volatility in the equity markets.
Open-ended bond mutual funds appear to be the likeliest targets to be hit first. As redemptions of fund shares come in, portfolio managers usually sell their best bonds first, and as time progresses, lower quality and lower priced bonds are redeemed. Yet, if you remain in the fund at year end, your values may have declined BUT you end up with a capital gains bill if the bonds the fund manager sold to meet redemptions were sold at a gain. So, we’re going to trim out much of our open-ended fixed income exposure.
Over the past 30 years, leveraged closed-end fixed income funds have consistently outperformed the bond indexes because they have been able to borrow funds at short term rates to buy longer term, higher yielding bonds, producing excess income for their owners. We know that they have tended to be more volatile than the indexes but at levels, in a declining to flat rate environment, generally commensurate with the higher duration risk that accompanied these vehicles. As short term rates rise, however, the spread between the cost of borrowing and the higher yields from longer term bonds can narrow, putting pressure on these funds’ distributions. The theory is that presumably the fund managers can roll out of their long term bonds into higher yielding longer term bonds, but if the yield curve flattens, as it appears to be doing at present, then it becomes a challenge to maintain both current distribution rates as well as net asset values. Finally, because closed end funds are traded on the market exchanges their prices are set by willing buyers meeting the prices of willing sellers. When there is a rush to the exits and sellers outnumber buyers, these fund prices will drop below the value of their assets (net asset value) and they will trade at a discount. We want to avoid the drop and be available with cash to reinvest on the back end of this cycle.
Shares of Exchange Traded bond funds are traded on the market exchanges, created on a continuing basis based upon demand, and priced based upon market valuations throughout the day. There are two fundamental types of Exchange Traded Funds (ETF’s): passive, which are generally linked to a benchmark index like the Barclays/Bloomberg Aggregate Bond Index and active, in which a real live portfolio manager is making decisions including managing credit risk, investment rate risk, spread risk, volatility risk, regulatory risk, and tax implications for investors. In the present environment, we are of the school who believe that active managers can add some additional performance to fixed income portfolios, particularly in the current environment.
We like individual bonds as well as the actively managed ETF’s. When we purchase an individual bond, we know, subject to several of the risks mentioned above, that we will receive the par value of the bond at maturity, or on an early call and, during the term of the bond, interest at the stated coupon rate. The one concern that we have in building these portfolios is a deterioration of credit worthiness attributable to all the debt that has been incurred over the past decade by government, municipal, and corporate issuers. As a result, we know that we must do a thorough job in carefully reviewing portfolios of individual bonds.
Over the coming weeks, this part of your portfolio will be under pressure. We are going to do our best to maintain income streams and meet cash flow needs against the need to preserve capital. This environment will be the most challenging we’ve managed through over the past 35 years in the bond world. We are thinking about this, acting accordingly, and believe that we will successfully navigate the challenges ahead.
[i] Source: FactSet
[ii] Source: “Managing Fixed Income” April, 2018, First Trust