By Kevin Kelly, Partner/Portfolio Manager
Fixed income is considered boring and simply can’t compete with the latest “hot” stock on CNBC, although the past two years have given fixed income investors something to appreciate. Intermediate corporate bonds outperformed the average stock in the S&P 500 in 2022, this year thru 10/31/23, and in the 2-year period ended 10/31/23. These facts would surprise many investors who think that “fixed income” has been a drag on their investment performance. Notably, those figures highlighted intermediate corporate bonds. Unfortunately, some investors got way too exposed to interest rate risk by owning long-dated bonds and they were hurt. The intermediate corporate bond index (1–10-year bonds), which include all investment grade rated bonds, currently has a yield of nearly 6%. At ACM, we aim to do even better than this with diligent security selection and active management. This yield is highly attractive for an investment with significant downside protection. Therefore, despite a rising interest rate environment over the past two years, intermediate corporate bonds have modestly outperformed the average S&P 500 stock and, looking forward, offer compelling positive returns.
We discussed bonds compared to the “average stock” in the S&P 500, because Intermediate corporate bonds in 2022 and 2023 combined have marginally underperformed the “actual” S&P 500 (due to the “Magnificent 7” stocks). We say “actual” because the S&P 500 is not quite what many retail investors think it is. Many investors often forget the S&P 500 is a market capitalization weighted index. This means the larger the company’s market cap, the larger its stock’s weight in the index. Hence the top 10 companies comprise more than 33% of the index, and the top 33 companies constitute over 50% of the S&P 500 index. This is the dynamic that financial advisors and clients are forced to deal with as they seek both diversification and performance simultaneously. Unfortunately, when a short list of the largest stocks drives the S&P 500 up or down, you simply can’t have both at the same time.
For those still on the sidelines afraid to invest in fixed income given the volatile rate environment, we highlight three points we have discussed in the past that are especially relevant today. First, the Federal Reserve is clearly in the late innings of the current rate hike cycle. While the length of time that interest rates will remain at current levels is a subject for hot debate, the current Fed Funds rate at 5.25-5.50% is well in excess of the current long-term median Fed Funds forecast of 2.5% (as of September 2023 Fed meeting). So even the Fed agrees the Fed Funds rate is forecasted to decline over the next few years. Second, the Fed Funds is an overnight rate between banks. Investors often forget the Fed does not control intermediate (3-10 years) or long-term (10-30 years) Treasury rates, which are the rates that drive bond prices. Bonds are not priced off the Fed Funds (overnight) rate. If the market expects the Fed will cut interest rates, then intermediate and long-dated Treasury rates, which drive bond prices, will likely react in advance. For example, although the Fed has not yet cut the Fed Funds rate, Treasuries have already declined significantly from their mid-October peak. Third, investing in money market or very-short dated securities exposes investors to significant reinvestment risk if/when short-term (0-3 years) interest rates decline. Eventually short-term rates will peak and will decline. Once again, investing very short term is attempting to time rates which we discourage. If interest rates do decline, these investors have not locked up current rates for any significant period of time. However, those who own intermediate bond portfolios have locked in rates / yield for longer and will benefit from total return (bond prices increasing) if/when rates fall. Notably, we are not encouraging investors to take significant duration risk and lock up rates for longer (we recognize this could potentially make sense for a small portion of investors). Investors often forget that long-term rates are influenced by many factors that are more challenging to predict, such as government deficits, the size of the government debt burden, the long-term global growth and inflation, and the attractiveness of Treasury rates versus foreign interest rates. Predicting these factors for a decade or more is clearly difficult.
For your individual asset allocation decision, we recommend that you speak with your advisor, but often fixed income does not get the proper attention it deserves. While the past two years have been choppy in fixed income and rates were extremely low during the Covid pandemic, interest rates are significantly higher now. We have mentioned it before, but we feel compelled to remind investors that interest rates are still near 15-year highs. This comes at a time when the Fed is committed to getting inflation closer to its 2% target. This sets up a potentially favorable environment for fixed income to meaningfully contribute to positive portfolio performance. Even if intermediate rates (3-7 years) stay at current levels or rise somewhat, the probability of positive fixed income returns in the near term seems more likely than not. A relatively low duration portfolio (intermediate corporate benchmark has a duration of ~4 years) with a yield of approximately 6% can withstand some interest rate increases while maintaining strong positive returns. Therefore, we strongly encourage investors to ensure they are positioned to take advantage of the currently attractive fixed income environment.
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.