Fixed income flexibility in an uncertain market environment
For the first time in three months, the overall U.S. bond market, as measured by the Bloomberg Barclays U.S. Aggregate Bond Index, posted a positive return in November. Meanwhile, market volatility has been on the upswing given ongoing concerns over trade wars, uncertainties surrounding future Federal Reserve (Fed) monetary policy and signs of moderating growth overseas. We recently spoke with Portfolio Managers Stephen Cianci and Neil Moriarty of MacKay Shields for their insights on the current environment and where they see attractive opportunities in the marketplace.
The Peak of the Economic Cycle?
While the most current reading for third quarter gross domestic product (GDP) growth in the U.S. was a robust 3.5%, there are indications that a peak in the lengthy economic cycle may be approaching. Unemployment is near a 50-year low in the U.S. and the Fed raised rates for the fourth time in 2018 at its December meeting. In addition, the fiscal stimulus, which has boosted the economy and propelled corporate profits sharply higher in recent quarters, is expected to fade in 2019. And economic growth in Europe and China has moderated, which could trickle down to the U.S. Finally, the U.S. Treasury yield curve is relatively flat, which often foreshadows slower growth.
Source: US Treasury as of 12/12/18. Past performance is no guarantee of future results, which will vary.
Playing Defense in the Fixed Income Market
While we do not foresee a U.S. recession in the foreseeable future, in our opinion, the current backdrop warrants a somewhat cautious approach in the fixed income market. The following are a number of strategies to consider that may help to reduce a portfolio’s overall risk profile.
Favor Intermediate Term Bonds
Given the slope of the yield curve and the likelihood of additional Fed monetary policy tightening, we currently favor the intermediate portion of the U.S. yield curve, with maturities in the 3-, 5- and 7-year range. In our view, this segment of the curve offers more attractive risk-adjusted return opportunities. Consider the 5-year portion of the curve. It currently offers approximately 90% of the yield available from 30-year securities, with one-third of the interest rate risk.
Adjust Corporate Bond Allocations
With corporate profits likely peaking, we believe an “up in quality” bias in the investment grade corporate bond market is warranted. It may also be prudent to emphasize more non-cyclical sectors versus cyclical sectors, given the potential for less robust growth. We also believe security selection in the BBB-rated market—the lowest tier of the investment grade universe—remains paramount. In 2007, BBBs represented roughly 32% of the Bloomberg Barclays U.S. Corporate Bond Index. Today, this has grown to 51%. Meanwhile, the overall high-yield market has remained fairly static at around $1.2 trillion in recent years. Should the economic growth decelerate, there is the potential of ratings downgrades to high-yield which could lead to spread widening. Against this backdrop, having a thorough understanding of the underlying fundamentals of BBB issuers takes on added importance.
Investment Grade Corporate Ratings
Source: Bloomberg Barclays as of 12/12/18. Past performance is no guarantee of future results, which will vary.
Boost Structured Product Allocation
It may be beneficial to increase a portfolio’s allocation to structured products, such as asset-backed securities (ABS), residential mortgage-backed securities (RMBS) and commercial mortgage-backed securities (CMBS). These securities are generally high quality and with our focus on the short to intermediate part of the curve, they tend to have less interest rate risk. Along with less volatility, structured products offer the potential for reasonable returns versus their corporate credit counterparts and offer spread diversification.
Pare an Allocation to Floating Rate Bank Loans
Year-to-date through the end of November, floating rate bank loans have been the best performing sector in the U.S. fixed income market, although they have gotten caught up in market volatility more recently.1 Over this time, they’ve enjoyed the tailwind from rising LIBOR rates that has allowed them to reset their rates higher. However, given current valuations, along with the prospect for more muted growth and less inflationary pressures, we believe paring one’s exposure to bank loans makes sense. Within this market, we favor higher quality deals that may be less susceptible to slower growth.
Diversifying with a Multi-Sector Investment Approach
To be sure, the trajectory for the U.S. economy, rates, and Fed monetary policy is uncertain. In addition, some of the macro issues that have recently led to flights to quality and pushed rates lower remain in place. Against this backdrop, we feel a multi-sector and unconstrained investment approach makes sense, as it allows a portfolio manager to remain flexible and allocate assets across the fixed income universe in an attempt to generate the most attractive risk/return returns.
1. Morningstar, November 30, 2018
Past performance is no guarantee of future results, which will vary. All investments are subject to market risk and will fluctuate in value. Funds that invest in bonds are subject to interest-rate risk and can lose principal value when interest rates rise. Bonds are also subject to credit risk, in which the bond issuer may fail to pay interest and principal in a timely manner, or that negative perception of the issuer’s ability to make such payments may cause the price of that bond to decline. Investing in below investment grade securities may carry a greater risk of nonpayment of interest or principal than higher-rated bonds.
This material represents an assessment of the market environment as at a specific date; is subject to change; and is not intended to be a forecast of future events or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice regarding the funds or any issuer or security in particular.
The strategies discussed are strictly for illustrative and educational purposes and are not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. There is no guarantee that any strategies discussed will be effective.
This material contains general information only and does not take into account an individual’s financial circumstances. This information should not be relied upon as a primary basis for an investment decision. Rather, an assessment should be made as to whether the information is appropriate in individual circumstances and consideration should be given to talking to a financial advisor before making an investment decision.
A credit spread is the difference in yield between two bonds of similar maturity, but different credit quality.
Floating rate investments are generally considered to have speculative characteristics that involve default risk of principal and interest, collateral impairment, non-diversification, borrower industry concentration, and limited liquidity
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.
The London Interbank Offered Rate (LIBOR) is the average interest rate estimated by leading banks in London that they would be charged if borrowing from other banks. It is a primary benchmark for short-term interest rates around the world.
High-yield securities carry higher risks, and some of the Fund’s investments 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.
The Bloomberg Barclays U.S. Aggregate Bond Index is a broad-based benchmark that measures the investment-grade, U.S. dollar-denominated, fixed-rate taxable bond market, including Treasuries, government-related and corporate securities, mortgage-backed securities (agency fixed-rate and hybrid adjustable-rate mortgage pass-throughs), asset-backed securities, and commercial mortgage-backed securities.
Barclays U.S. Credit Bond Index is the most common benchmark used to measure the U.S. credit bond market. The index measures the performance of investment grade corporate debt and agency bonds that are dollar denominated and have a remaining maturity of greater than one year
The S&P 500 Index is a capitalization-weighted index of 500 stocks. The index is designed to measure performance of the
High yield corporate bonds are represented by the Bloomberg Barclays High Yield Corporate Index, which measures the USD-denominated, high yield, fixed-rate corporate bond market. Securities are classified as high yield if the middle rating of Moody’s, Fitch and S&P is Ba1/BB+/BB+ or below. Bonds from issuers with an emerging markets country of risk, based on Barclays EM country definition, are excluded.
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.
New York Life Investments is a service mark and name under which New York Life Investment Management LLC does business. New York Life Investments, an indirect subsidiary of New York Life Insurance Company, New York, New York 10010, provides investment advisory products and services. NYLIFE Distributors LLC is located at 30 Hudson Street, Jersey City, NJ 07302. NYLIFE Distributors LLC is a Member FINRA/SIPC.