By Kevin Kelly, Portfolio Manager
Given low Investment Grade yields, inflation concerns, and investors’ need (or desire) to stay invested, many fixed investors have found themselves chasing higher yield. Too often, most investors do not know when to stop chasing yield and either to accept a lower, safer yield or switch into other asset classes to try to secure a yield of 6% or higher. Investors are currently using three common methods to enhance fixed income returns: High Yield bonds, fixed coupon preferreds, and longer-dated Investment Grade bonds. Yes, opportunities do exist in each of these three categories, but the typical opportunity is currently not compelling when considering the level of risk most fixed income investors are willing to accept.
The High Yield market has been exceptionally strong since the 2020 lows. The Global Financial Crisis taught investors the importance of discipline in High Yield security selection. Nonetheless, it appears that many investors are dabbling in High Yield without taking the time to distinguish solid credits from very speculative ones. Also, owning long-dated High Yield bonds exposes investors to multiple economic cycles during which companies could run into potential financial issues. Many High Yield companies are issuing bonds at or near record low yields. The graph below highlights that the yield on the lowest quality High Yield rated bonds, CCC and lower, is extremely low. While yields are low across fixed income, investors who are buying a basket of CCC bonds yielding 7.5% should probably be invested in equities if they desire such high returns and are willing to accept such substantial risk. To help put this into context the default rate on CCC/C rated bonds in each of the past 6 years has been greater than 25%. By contrast, the annual Investment Grade default rate is below 0.5% in each of the past 20 years. If investors chose to own High Yield, we would strongly recommend owning higher quality, shorter-dated securities where we are still finding attractive opportunities.
There are many wrinkles with preferred securities that often makes each one unique. While a bond commonly has a fixed coupon, a preferred can have a fixed, floating, or an initially fixed coupon that floats in the future. While a bond has a set maturity date, preferreds typically have no maturity, which means they can permanently trade below their par (or face) value. We are seeing investors purchase preferreds with coupons in the low-4% range. These investors would lose around 20% if comparable preferreds traded down to push yield to 5%. A 1% move in interest rates and/or credit spreads (risk premiums over comparable treasuries) could happen if inflation proves to be more systematic and/or the economy worsens. For this reason, we purchase higher fixed coupons preferreds or preferreds whose coupon will become floating. This approach mitigates the risks of both interest rates rising and/or credit spreads widening.
Other investors prefer to own only Investment Grade (IG) bonds that are above a certain minimum yield. This has led some investors to purchase longer-dated Investment Grade bonds. We would strongly advise against this approach as it entails a significant amount of both interest rate and credit risk. High quality, Investment Grade securities rated A are currently yielding less than 3% for a 30-year bond. A 1% increase in interest rates will result in losing approximately 5 years of return. That is a risky proposition to hope to earn just a 3% yield. A more creative IG-only strategy could yield over 2% with a small fraction of such interest rate and credit spread exposure. We would strongly encourage any investor that is not an insurance company with long-dated obligations to reconsider whether locking in a low yield for such a long period of time is worth it.
The fixed income market is currently facing risks from both higher inflation and interest rates. Inflation remains elevated due to rising energy and food prices, continued supply side bottlenecks, and strong retail sales. High energy prices are occurring at a seasonally strong period for power demand as winter approaches in the Northern Hemisphere. Food prices and continued supply side bottlenecks throughout the economy will take time to resolve since supply chains were not created to withstand a global shutdown and sudden reopening. Simultaneously, the labor market remains very tight with the unemployment rate at 4.8% and average hourly earnings up 4.6% on a year-over-year basis in September. The labor market tightness is expected to continue, as best evidenced by near record job openings and exceptionally high quit rates of 25% in 2021 thru August. With so many firms trying to hire, it is unlikely wage pressure will reverse. It is a matter of debate whether inflation will worsen or moderate now that in-person schooling has resumed in most countries. In the background, the Fed wants to keep long-term inflation expectations anchored around 2% per year. For these reasons, we are choosing to keep duration relatively short to mitigate inflation and interest rate risk.
We think investors should be clear about the objective for owning fixed income in their portfolios. Many investors seek safety and preservation of capital. Other investors prefer to target incremental yield for a moderate amount of incremental risk. Unfortunately, some fixed income investors seem to be pushing the envelope on what is a prudent amount of fixed income risk. For investors who demand a 6% or higher yield on their investments, those investors may want to consider if there are more attractive opportunities in equities or other asset classes. We encourage investors to be creative but to remain disciplined. At ACM, we do this by focusing on the lower-end of Investment Grade, BBB-/BBB, and purchasing select preferreds that we think are offer compelling risk adjusted yields for clients.
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.