| wealth management  by Jay P. Nicholls, CFA®| Director of Trading

Executive Summary

  • Interest rates have been falling for decades, but investors still need income
  • Increasing income comes at a cost of increasing risk
  • A selective allocation to higher-yielding segments of the bond market may be appropriate

The current environment of historically low-interest rates creates severe challenges to investing bond portfolios. Interest rates have been falling for forty years, so replacing current income in a traditional bond portfolio is not a new task. The Covid-19 pandemic brought declining rates to a new nadir, and the yield on the 10-year U.S. Treasury fell to a low of 0.5% last year. The rate peaked near 16% in the early 1980s (see Figure 1 below). Much of the developed world has exhibited a similar pattern, even reaching negative yields in several countries. Today, the U.S. 10-year Treasury has one of the highest yields of any country in the G7, despite yielding around 1.6%. To achieve higher returns, investors are forced to accept additional risk from the “safer” part of balanced portfolios while adjusting long-term expectations for fixed income returns. The current challenges require professional investors to take a more active approach to managing fixed income than at any point in recent history.

 | wealth management

Source: Bloomberg

Boston Financial Management (“BFM”) has two main levers to consider pulling, increasing the duration of the portfolio (taking interest rate risk), or buying securities other than those of the U.S. government, namely corporations (taking credit risk). Let’s discuss both in more detail below.

Cautious on interest rate risk

Duration is an important calculation of bond risk, but what does it mean? Duration measures the sensitivity of a bond’s price to a change in yields. For example, a bond (or portfolio) with a duration of ten years means that for every 1% shift up in yields, there is a 10% drop in the price of the bond. Duration is commonly referred to in years because it is a function of the timing of a bond’s cash flows (coupons and principal repayment). The more distant the cash flows, the higher the sensitivity to a change in interest rates. Said simply, the longer the maturity, the higher the duration. Since bond prices move inversely to interest rates, the higher the duration, the more risk associated with rising interest rates.

For example, the value of a bond (or portfolio of bonds) with a duration of 10 years means that for every 1% shift up in yields, there is a 10% drop in the price of the bond. A bond with a duration of five years will only see a 5% decline in its price.

With interest rates declining for decades, long-duration was a tailwind for returns for many years, but this has shifted into a headwind since the low in rates last year. Interest rates can rise for multiple reasons, such as an improving economy or rising inflation (click here to read BFM’s piece on inflation), both of which we have experienced this year. The United States economy grew an eyepopping 12.2% through the second quarter this year compared to a year ago. The latest reading of inflation, as measured by the Consumer Price Index, hit 5.4% in September compared to last year. That is the highest reading since at least 2008. The Federal Reserve (Fed) can also raise short-term rates and it has intentions to do so when the time is right. Additionally, interest rates can rise if/when the Fed wants to pull back on the accommodative policy enacted last year to help stabilize markets.

Today, many experts are forecasting higher rates, citing an improving economic backdrop and an increasingly hawkish Fed. Our view is consistent with this consensus opinion; the bias for rates is higher. The inflation and growth we see today seem incongruent with the absolute level of interest rates, considering that a 30-year U.S. Treasury Bond pays just over 2%! We feel investors are not compensated fairly given the interest rate risk of a long-term bond, which is why BFM has chosen to keep the duration of bond portfolios low. This has done a fine job protecting capital in what has been a tough year for longer-term bonds.

Prefer credit risk

Outside of duration risk, we do see some other opportunities to improve returns. Typically, investors demand a higher return for lending their money to a less credit-worthy borrower. The additional yield, or spread, an investor can earn from moving down in credit ratings can increase the yield of a bond portfolio. That spread tends to behave cyclically; when prospects for companies are bleak, investors demand a higher return to assume the additional credit risk. Today, credit spreads are low, but this is for good reason. The economic rebound post-pandemic remains strong despite a summer slowdown due to the delta variant. Consumer spending is growing, employment is gaining, and, importantly, corporate profits are surging (see Figure 2 below). Low-interest rates over the past year have led many issuers to refinance their outstanding debt at cheaper, more attractive levels. Now flush with cash, companies can ensure that bondholders get the interest payments they were promised. The expected chances of bond issuers defaulting on their debt have decreased.

 | wealth management
Source: Bloomberg

Even in a favorable environment, increasing credit risk must be managed selectively. Successful bond investing requires avoiding losses and steering clear of high-risk issuers that are likely to get downgraded, or even default. Reaching for too much yield is a dangerous game that can lead to lower realized returns due to issuers defaulting on their obligations. We want to lend to issuers with improving fundamentals, who are not overly indebted and have the capacity to repay their debts.

So what are we doing in fixed income portfolios?

The primary roles of fixed income are to mitigate portfolio volatility, preserve capital, and provide income. We believe allocating to high quality bonds across various segments of the fixed income landscape will provide these attributes over the long run.

We continue to recommend owning investment-grade corporate bonds, which offer a better return outlook than U.S. Treasuries. Additionally, we recommend investors hold relatively short-duration bonds to avoid taking excessive interest rate risk, given our concerns about the sustainability of the current low-rate environment.

Outside of these core tenets, we see opportunities to enhance portfolio return by selectively adding a small allocation to non-investment grade bonds. We would focus on the highest rated companies in the non-investment grade universe (i.e. BB-rated issuers) for two reasons: they have historically generated higher risk-adjusted returns relative to investment-grade bonds and have seen relatively low default rates compared to lower-rated bonds. In the chart below, you can see that default rates have recovered rapidly from the depths of the pandemic for U.S. non-investment grade issuers (see Figure 3 below). Furthermore, Fitch Ratings predicts that default rates for 2022 will fall even further¹. Given the improving economic backdrop, attractive expected returns, and low default rates, we think this creates an attractive opportunity for portfolios today.

 | wealth management

Conclusion

We understand that many people expect income from their investments. With yields across asset classes low relative to history, it can be challenging to find high income-producing assets without taking undue risk. Our approach uses a selective and disciplined process to help build bond portfolios with appropriate risk controls that meet the income needs of our clients in accordance with their long-term goals and objectives.

The team at Boston Financial Management is always available to answer your questions. Please do not hesitate to contact your Wealth Manager directly or call our main line at 617-338-8108.

Market Commentary Disclaimer

This publication is for informational purposes only and should not be considered investment advice or a recommendation of any particular security, strategy or investment product. The information contained herein is the opinion of Boston Financial Management and is subject to change at any time based upon unforeseen events or market conditions.

Professional Designation Minimum Requirements Disclosure

CFA® – Chartered Financial Analyst. Minimum requirements for the CFA® designation include an undergraduate degree and four years of professional experience involving investment decision-making, in addition to successful completion of each of the three CFA level examinations.