by: Steven P. Saunders, CFA, CAIA

 

Market Summary

As we enter the second half of 2022, investors are hard pressed to see any clearing in the preverbal storm to hit markets. Stubbornly high inflation initially triggered by the pandemic has yet to improve as the war in Ukraine and continued lockdowns in China have thrown fuel on the already red-hot supply chain fire. Inflation remains at or near the highest level in over 40 years and the ramifications were felt across financial markets. Most equity markets are in correction territory (down over 10% YTD), and many are in bear markets (down over 20% YTD). While disappointing to see equity portfolios decline double-digits, equity markets have a long history of getting through challenging periods of volatility. Perhaps more disappointing has been fixed income market returns, which are down 13.9% year-to-date through June 30 as measured by the Bloomberg Global Bond Aggregate Index. The negative fixed income returns experienced so far this year are far in excess of what fixed income investors have historically experienced and the opposite of what many would expect when equity markets have tumbled as they have, leaving many to question if fixed income still serves a purpose in portfolios. We believe that not all fixed income is created equal and that we are in the midst of a transitional period. As evident by our positioning within fixed income through the first half of the year, investors can still allocate to fixed income during this volatile period and achieve the goal of preserving capital, reducing volatility, and generating income if they look in the right areas.

Bond Math

To understand what has happened so far in 2022 we have to understand the dynamics of fixed income. Fixed income at its core is basic math. A bond is simply a loan offering money to an entity in exchange for an interest payment during the life of the loan and the return of capital at the end of the loan. As interest rates change, investors adjust the value of that bond based on whether it is more or less attractive versus current interest rates. If interest rates move lower, that bond is yielding more than what is currently available, so the value of the bond goes up. If rates move higher, that bond is yielding less than what is currently available. Therefore, the value of the bond goes down to compensate the purchaser in order to achieve a market return over the life of the bond. This is referred to as an inverse relationship between interest rates and bond prices. In a year when interest rates have increased 1.5% as measured by the 10-Year Treasury, the bond math means bond prices have decreased.

While rates have increased, the caveat to a decline in prices is that some bonds will experience much larger drawdowns in prices as rates increase due to their duration, which is primarily a function of their expected bond maturity or the length of the loan. A loan that will be repaid further out in the future such as a 30-year loan (a long-term bond), will see a price decrease more than a loan that is expected to be repaid in a couple of years (a short-term bond), all else equal.
This is due to the long-term bond “locking in” a lower interest rate payment on the capital loaned out than what is currently available in the marketplace, resulting in missed opportunities for the purchaser to earn more yield in a higher rate environment. Short-term bonds on the other hand may see their prices decline, but an investor can lock-in a higher rate in just two years once the bond matures so the opportunity cost is much lower, resulting in a much more muted change in price.

Rates

Understanding the inverse relationship of bond prices and rates along with the impact of duration helps explain performance of different areas of fixed income during the first half of 2022. Interest rates across all maturities have increased materially this year with common maturities and the corresponding total return referenced below. Longer maturity bonds have suffered the largest drawdowns while shorter maturity bonds have declined far less despite short-term rates actually increasing more than long-term rates. If rates continue to increase, short-duration bonds can continue to be more defensive. An analysis by Goldman Sachs Asset Management suggested that the 2-Year Treasury yield would need to increase 132 bps for the price decline to eliminate one year of income while the 10-Year Treasury yield would only need to increase 34 bps for the price decline to eliminate the annual yield*.

* Goldman Sachs Asset Management. Market Know-How as of May 31, 2022. 

Round Table Positioning

At Round Table, our fixed income positioning began to focus on short-duration fixed income during 2021 and continued into a turbulent 2022. Short-term rates began to adjust higher in late-2021 and it was our concern at that time that intermediate and long-term rates would follow suit as inflation remained above trend and economic growth was still positive. This short-duration positioning was designed to be more defensive as short-term rates continued to move higher, which best achieves the goal of capital preservation. Additionally, coming into 2022, investors could generate a similar yield in short-duration bonds versus longer maturities as the yield curve was historically flat. This meant that investors were not getting compensated for duration risk and investing in short-duration bonds allowed for a more defensive way to achieve the income goal of fixed income.

While we are pleased with how our short-term positioning has behaved this year, we continue to evaluate if the positioning is still warranted based on current and expected market conditions. Based on current yields and rate volatility, we continue to favor short-duration fixed income but are monitoring relative yields across maturities and expected inflation rates to determine where the best value is across the curve. Due to the rapidly changing rate environment, short-duration bonds allow us to pivot relatively quickly if opportunities arise in longer maturity issuers.

Credit

Maturity positioning only tells half the story of fixed income with credit positioning comprising the other half. U.S. Treasuries are used to evaluate how changes in rates are impacting fixed income returns, as they are considered “risk-free.” This means  there is (theoretically) no default risk. However, most fixed income allocations are not exclusively invested in U.S. Treasury bonds and allocations will often include an allocation to bonds from issuers that are not risk-free and have at least the possibility of default risk. These allocations include fixed income securities like corporate bonds, mortgage bonds, floating rate bonds, commercial mortgages, and asset-backed securities. While there is the potential for default in these investments, investors are compensated for this risk with a higher yield than what is available in similar maturity U.S. Treasuries. The higher yield compared to U.S. Treasuries is referred to as the “spread” of the bond and just as bond prices move in the opposite of interest rates, they also move in the opposite direction of spreads (i.e., when spreads increase, bond prices decrease).

As depicted, returns across these different fixed income assets range year-to-date from about -9% to over -14%. While duration has had an impact on these returns with the Bloomberg U.S. Corporate Index down the most due to the longest duration, the credit consideration has also impacted returns as the higher risk of recession has resulted in investors demanding more of a yield to compensate for this risk (i.e., a higher spread). The same can be said about U.S. Corporate High Yield index, which has a relatively low duration but is more sensitive to credit spreads as these companies are at higher risk of default, resulting in this index returning over -14% in the first half of 2022. 

The outlook on credit has become more clouded in recent weeks as companies grapple with higher energy costs, higher input costs, and potentially waning consumer demand. At the same time, companies must evaluate how rising interest rates impact their balance sheets. The good news is that many companies have taken advantage of the low interest rate environment over the last year by taking out debt at very low rates (much like how consumers have refinanced their mortgages when rates were 3% or less). This has resulted in many companies locking in very low debt payments for many years to come. Investment grade issuers have the luxury of issuing (or taking out) debt that is repaid in 20 years or more. Issuers with below investment grade ratings generally are not afforded this luxury but they have still been able to refinance or issue debt over the past few years to be paid back in five or more years. This means that while the cost of issuing or refinancing debt has increased this year, the impact is relatively muted as companies previously locked in a significant portion of their debt at low rates. According to data compiled by Bloomberg, just 8% of all high yield debt outstanding will need to be paid back by the end of 2024, giving the majority of companies breathing room if there is a pending economic slowdown. To be fair, companies will still need to issue debt in the higher rate environment in order to continue to grow and expand, but this adjustment should be digestible for companies as absolute borrowing rates remain reasonable in the historical context and the need to refinance existing debt is limited.

Round Table Positioning

As interest rates have been historically low for over a decade, we have long favored fixed income asset classes other than U.S Treasuries as a way to generate additional income. Diversified core bond funds have favored allocations to investment grade corporates and mortgages as these offer a higher yield with little added default risk during most market environments. We agree with this approach and use these funds to generate additional yield within portfolios while continuing to hold high quality assets.

Investors looking for even more yield can allocate to riskier bonds in the form of below investment grade fixed income. While the default risk within these bonds is higher than other asset classes, defaults occur in cycles, meaning most of the time, defaults are low, but they will spike during times of economic hardship. Knowing when and more importantly when not to invest in below investment grade bonds is key to capitalizing on the added yield as defaults can quickly eliminate years of the yield premium. While the overall economic outlook has tempered and recession risks have increased, a major default cycle may be limited compared to past cycles as many companies have locked in attractive longer-term financing. As such, we are comfortable with holding below investment grade allocations but are closely monitoring economic activity to ensure there are no major disruptions to this thesis.

Below investment grade exposure is primarily gained through floating rate loans, which comprise an overweight within client portfolios. These investments combine our positioning on the maturity and credit thesis into one investment, meaning low duration with yield premiums. Floating rate loans are different than other fixed income asset classes because as the name suggests, the interest rate floats or adjusts based on current market dynamics. This means that the prices of these loans will be relatively stable in the face of changing interest rates (both higher and lower rates) assuming credit quality remains stable.

Outlook & Positioning

While we do not set specific interest rate targets, we do form expectations of potential trends in rates. If focusing on the 10-Year Treasury, rates have increased materially on the absolute level from its recent low of 1.13% on 8/4/2021 to a peak of 3.47% on 06/14/2022. This is the third highest trough-to-peak change in 10-Year yields going back to 1998 according to Bloomberg, but what has made it the most painful is the speed at which it occurred with the change occurring over the last nine months. If the past is any indication, there may be additional room for higher rates, but the largest adjustments may be behind us. While increasing odds of a recession could lead to rates declining in the future, elevated inflation and a Federal Reserve focused on raising rates to tame inflation will also likely keep rates elevated.

For investors that hold fixed income, the adjustment period of rapidly higher rates has been hard to stomach but the silver lining is that yields are once again returning to levels that are accretive to portfolios. The adjustment lower in bond prices as a function of higher rates is just that, an adjustment, but ultimately fixed income investors will be rewarded with higher interest payments that will compensate for the negative price return seen on a mark-to-market basis.

Round Table Positioning

With higher rates and higher spreads, various options for how to invest in bonds have become more attractive. Access to fixed income can come in different forms such as buying bonds outright, using an actively managed bond fund, or a passively managed bond ETF. All forms have their place in portfolios but for investors that want predictable income, higher rates now allow investors to take advantage of laddered bond portfolios. A laddered bond portfolio allocates an equal percentage of portfolio assets to each maturity throughout a given range.  For instance, an investor can purchase 25% of their allocation to 1-year bonds, 25% to 2-year bonds, 25% to 3-year bonds, and 25% to 4-year bonds. In year 1 when 25% of the portfolio matures, the investor would then use proceeds to buy new 4-year bonds, effectively rolling capital into a perpetual 1-4 year bond ladder. The structure allows for predictable cash flows and provides a reasonable expectation of total return; provided there are no credit events, or bonds sold prior to maturing. Additionally, if rates continue to move higher in one years’ time, investors can capture that increase in yields through the bonds that are maturing. Depending on the steepness of the yield curve, the investor has the opportunity to increase duration to capture higher long-term yields.

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