Active Management Matters in Fixed Income

By Portfolio Managers, Kevin Kelly & Kevin Strauss

The past five years have highlighted the importance of active management in fixed income as
seemingly what worked in one year has not worked well the next year. While we do not pretend to anticipate all market movements, we firmly believe that astute portfolio managers can monitor economic data, and then do their best to react accordingly. We regularly hear that many fixed income investors simply buy brand name bonds (issuers that every retail investor knows), and then hold until maturity without evaluating other options. At ACM, we believe active management can add value versus a passive approach, as the market is dynamic. We also think an active approach is optimized by owning individual securities. The discussion below highlights how the market has presented opportunities in each of the last five years for active management to create value.

In 2019, both interest rates and credit spread declined significantly. The Fed cut the Fed Funds rate three times for a total of 0.75% during 2019, as 4Q’18 GDP was weak and inflation, as measured by CPI, declined to 2% in 2019 after touching nearly 3% in July 2018. This led to the 2, 5, and 10-year Treasury rates all declining by 0.75%-1.00%. Credit spread tightening was driven by the risk-on sentiment, as the S&P returned over 31%. As 2019 progressed, defensive portfolio management was focused on ensuring portfolios were not too short duration. This is noteworthy because in 2018 many fixed investors were afraid of duration as interest rates seemed to be on an upward trajectory most of the year, which also drove up credit spreads, as fixed income investors became cautious.  Offensive strategy took advantage of declining interest rates and credit spreads, which created numerous opportunities. During 2019 ACM recognized that preferreds offered extremely attractive risk reward in 2019, as many issued in 2018 had much higher coupons than the prevailing market rate. The average preferred, as measured by PFF, the large preferred ETF, returned nearly 16%, which was in excess of both intermediate Investment Grade (IG) bonds and high yield (HY) bonds.     

2020 was a rollercoaster as the Covid pandemic led to a massive decline in interest rates approaching zero, and massive volatility in credit spreads. The 5-year and 10-year Treasury rate ended the year at extreme lows of 0.4% and 0.9% respectively. Even the 30-year Treasury finished below 1.7%. Credit spreads ended the year relatively flat in both IG and HY bonds as monetary and fiscal policy were aggressively utilized to prevent an economic meltdown. Then in late 2020, the vaccine provided relief to the market that pandemic concerns would eventually subside. Correspondingly, the very low-rate environment and massive stimulus contributed to an 18% return on the S&P 500. While hindsight is always 20/20, prudent portfolio managers (PMs) played active defense in 2020. At ACM, we focused on reducing both HY bond and preferred exposures to reduce downside risk as capital preservation is priority number one. On the offensive side, numerous opportunities arose during the market turbulence. We decided to conservatively play offense by buying short-dated, high-quality securities with very attractive yields. For example, some A- rated paper, maturing in less than one-year yielded around 5% because buyers were being paid handsomely to provide liquidity to select panicked sellers. Furthermore, ACM was able to selectively take advantage of opportunities to improve quality and yield.

2021 highlighted that many fixed income investors got complacent. Defensively, selling low yield securities became advantageous. This did not require any foresight because numerous brand name bonds with maturities of more than 3 years had yields of around 1%. Therefore, the upside on these bonds was minimal in nearly any interest rate environment. Many funds bought intermediate and long-dated bonds yielding below 1% because investors believed long-term rates would (unrealistically, in our view) remain extremely low; we consciously avoided such securities. Instead, ACM sold many securities that benefited from the strong market recovery to capture gains and redeployed proceeds into higher yielding or higher quality names with shorter maturities and less interest rate risk. For example, we sold one convertible bond when its price rose sharply (so that its yield had dropped to nearly zero) as the stock market recovery caused investors to chase upside potential in convertible securities. While we did not originally buy this security expecting to make such a nice profit, when the market presents opportunities like such a price spike, an active fixed income manager can capitalize on them.

2022 demonstrated just how many bond investors chased yield by taking substantial interest rate risk. Furthermore, very low yield and long-dated paper also comes with higher credit spread risk. The rising rate environment combined with the Russian invasion of Ukraine, which escalated geopolitical risk, resulted in many fixed portfolios getting severely hurt by both rates and spreads. In contrast, defensive oriented managers like ACM significantly reduced fixed rate preferred exposure. Early in the year we became confident that rates had more upside risk, so we moved on because fixed income should always be more about defense than offense. Additionally, we significantly reduced our already low exposure to long-term bonds. With interest rates low and credit spreads tight going into 2022, we focused on managing our duration risk (without taking our duration to an extreme low). Furthermore, we purchased treasury inflation protected securities (TIPS), which benefit from rising inflation. We found securities with attractive structures to minimize interest rate risk, while still offering attractive yields. In preferreds, we became extremely focused on variable/floating rate preferreds, which have coupons that reset to the interest environment (if not redeemed) and so provide protection against rising rates. For context, the variable rate preferred index, VRP, outperformed the large preferred ETF, PFF, by nearly 9% in 2022. Variable rate preferreds even marginally outperformed the intermediate corporate bond index.

It would have been easy to get whipsawed in 2023. In early 2023, interest rates declined before increasing, and are now higher for the year. Some investors may have decided toward the start of 2023 that rates had peaked and rushed prematurely to add duration. This proved too early, as inflation was not yet near the Fed’s 2% inflation goal. Keeping duration moderate and refraining from calling ‘peak rates’ has proven crucial. In our opinion, too many investors are making large interest rate bets. We think it’s more prudent to express a moderate interest rate view without making the portfolio’s performance primarily dependent on possible interest rate changes. This approach is simple as it requires discipline rather than accurately predicting interest rates. On the offensive side, the regional banking crisis created opportunities as securities from even the highest quality financials sold off dramatically. While nothing in investing is without risk, globally systemic significant banks do tend to have a higher margin of safety given their stricter capital requirements and large deposits bases. At ACM, we prefer to focus on high quality opportunities when an industry is under some stress, because the highest quality names often get lumped in with lower quality names.

While no portfolio manager can predict the future, an active management approach allows a manager to respond to current market conditions by taking advantage of unforeseen opportunities as they present themselves. Understanding the upside and downside risks of interest rates and credit spreads allows a PM to better position the portfolio. Purchasing single name securities allows this positioning to be more precise and the PM to be more selective. As the past five years have demonstrated, the fixed income market is dynamic and what works one year may not work the next. Therefore, an actively managed portfolio can benefit investors as it allows them to play both offense and defense.

The foregoing content reflects the opinions of Advisors Capital Management, LLC and is subject to change at any time without notice. Content provided herein is for informational purposes only and should not be used or construed as investment advice or a recommendation regarding the purchase or sale of any security. There is no guarantee that the statements, opinions or forecasts provided herein will prove to be correct. Past performance may not be indicative of future results. Indices are not available for direct investment. Any investor who attempts to mimic the performance of an index would incur fees and expenses which would reduce returns. Securities investing involves risk, including the potential for loss of principal. There is no assurance that any investment plan or strategy will be successful.