Navigating the fixed income market with a multi-sector approach
The fixed income market has experienced its fair share of volatility in recent months. Given uncertainties regarding the economic trajectory and continued Federal Reserve (Fed) rate hikes, this may continue as the year progresses. Against this backdrop, we recently spoke with Neil Moriarty and Steve Cianci from the Global Fixed Income Team at MacKay Shields to gain their insights on the fixed income market. They also shared a number of strategies to help manage the risk exposure in a fixed income portfolio going forward.
The late innings of the credit cycle?
The current economic expansion in the U.S. is now the second longest on record. While second-quarter gross domestic product (GDP) in the U.S. was the strongest since 2014, there are some signs that growth could decelerate, which could impact the current credit cycle. For example, the yield curve has meaningfully flattened. As of September 14, 2018, the spread between two- and 10-year Treasuries was only 21 basis points (bps). If this continues, the curve may invert, with two-year yields moving higher than their 10-year counterparts. In the past, this has been a forward-looking signpost for the economy, as it often foretells that a recession may be on the horizon. Another possible headwind for the economy could be continued interest rate hikes by the Fed.
10-year Treasury constant maturity, minus 2-year Treasury constant maturity
Source: Federal Reserve Bank of St. Louis, as of 9/13/18. Shaded areas indicate U.S. recessions.
The impact on the fixed income market
While a recession appears to be far from imminent, moderating economic growth typically impacts the fixed income market well beforehand. For example, high-yield credit spreads tend to widen as investors demand a higher risk premium for taking on additional credit risk. Meanwhile, longer duration bonds would likely be negatively impacted as the Fed continues to raise interest rates.
Proactively adjusting a fixed income portfolio
While it may not be possible to entirely negate the impact of rising yields and widening credit spreads, there are several strategies to consider that may help to manage a fixed income portfolio’s overall risk exposure.
- Shorten duration: One opportunity to help manage a fixed income portfolio’s interest rate risk is to shorten its overall duration. While shorter duration securities historically offered lower yields (as seen in the chart below) they have been less vulnerable to rising rates. Within the credit market, moving from longer maturity bonds more to intermediate- and shorter-term securities may help to manage a portfolio’s volatility.
- Adjust corporate bond allocations: Certain segments of the corporate bond market are typically less susceptible to an economic slowdown than others. For example, if suitable, it may be wise to shift from more cyclical sectors to non-cyclical sectors. Within the investment-grade universe, emphasizing relatively higher quality securities can be a useful strategy. Bonds rated BBB—the lowest tier of the investment-grade universe—now represents roughly 50% of the Bloomberg Barclays U.S. Credit Bond Index, with a total of $3 trillion debt.1 Should the economy falter, we believe, a portion of these securities would likely be downgraded to high-yield. It’s unlikely the market would have the capacity to absorb those assets in a timely basis and, should this occur, the implications for the spread markets could be dramatic.
BBB’s increasing share of investment-grade corporates
Source: Bloomberg Barclays, as of 9/14/18. Past performance is no guarantee of future results. An investment cannot be made directly into an index.
- Diversify fixed income sector allocation: Having an allocation to structured products, such as asset-backed securities (ABS) and commercial mortgage-backed securities (CMBS) may help diversify a portfolio. Structured products often have fairly short durations and may offer attractive yields as compared with their investment grade corporate bond counterparts.
- Consider floating rate loans: If suitable, allocating a percentage of a portfolio’s assets to bank loans may also be prudent. Bank loans are higher up the capital structure than subordinated debt, which may help manage credit risk. In addition, bank loans are floating rate assets, which can help to manage interest rate risk.
The flexibility of a multi-sector investment approach
Given the current economic environment and potential for decelerating growth, it may be prudent to review your fixed income portfolio with your financial advisor to see if adjustments are warranted. Multi-sector and unconstrained funds give a portfolio manager the flexibility to allocate across the fixed income spectrum and to focus on the asset classes with the most attractive risk/return profiles.
1. Bloomberg Barclays
Opinions expressed are current opinions as of the date appearing in this material only. The information and opinions contained herein are for general information use only. New York Life Investments does not guarantee their accuracy or completeness, nor does New York Life Investments assume any liability for any loss that may result from the reliance by any person upon any such information or opinions. Such information and opinions are subject to change without notice, and are not intended as an offer or solicitation with respect to the purchase or sales of any security or as personalized investment advice. There can be no guarantee that any projection, forecast, or opinion in these materials will be realized. Past performance is no guarantee of future results.
All investments are subject to market risk, including possible loss of principal. There is no assurance that the investment objectives mentioned will be met. Diversification cannot assure a profit or protect against loss in a declining market.
Mortgage and asset backed securities – The principal risk of mortgage-related and asset-backed securities is that the underlying debt may be prepaid ahead of schedule, if interest rates fall, thereby reducing the value of the fund’s investment. If interest rates rise, less of the debt may be prepaid and the fund may lose money.
Bonds are subject to interest-rate risk and can lose principal value when interest rates rise. Bonds are also subject to credit risk which is the possibility that the bond issuer may fail to pay interest and principal in a timely manner.
High yield securities (junk bonds) have speculative characteristics and present a greater risk of loss than higher quality debt securities. These securities can also be subject to greater price volatility. Diversification does not guarantee profit or protect against loss.
Treasury Securities are backed by the full faith and credit of the United States government as to payment of principal and interest if held to maturity.
Index performance is shown for illustrative purposes only and does not predict or depict the performance any specific investment. Indices are unmanaged, include the reinvestment of dividends and cannot be purchased directly by investors. Past performance does not guarantee future results.
The 10-year Treasury note is a debt obligation issued by the United States government with a maturity of 10 years upon initial issuance. A 10-year Treasury note pays interest at a fixed rate once every six months, and pays the face value to the holder at maturity.
Basis points (bps) refer to a common unit of measure for interest rates and other percentages in finance. One basis point is equal to 1/100th of 1%, or 0.01% (0.0001), and is used to denote the percentage change in a financial instrument.
Bloomberg Barclays U.S. Credit Bond Index – This index is the Corporate component of the U.S. Credit Index, a publicly issued U.S. corporate and specified foreign debentures and secured notes that meet the specified maturity, liquidity, and quality requirements. To quality, bonds must be SEC-registered.
Credit ratings agencies, such as Moody’s, Standard & Poor’s, and Fitch Ratings, have letter designations (such as AAA, B, CC) which represent the quality of a bond. Moody’s assigns bond credit ratings of Aaa, Aa, A, Baa, Ba, B, Caa, Ca, and C, with WR and NR as withdrawn and not rated. Standard & Poor’s and Fitch assign bond credit ratings of AAA, AA, A, BBB, BB, B, CCC, CC, C, and D.
Duration measures interest-rate sensitivity. The longer the duration, the greater the expected volatility as rates change. Fixed Income investing entails credit and interest-rate risks. When interest rates rise, bond prices generally fall, and a fund’s share prices can fall.
A yield curve is a curve on a graph in which the yield of fixed-interest securities is plotted against the length of time they have to run to maturity.
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