Investors allocating capital to fixed income generally are looking to achieve two main objectives: stability and moderate returns in excess of inflation. However, with central banks globally focused on providing unprecedented levels of accommodative policies, trillions of dollars of debt are currently trading at a negative yield. While U.S. rates remain well above zero, the 10-year Treasury bond has remained below 2% for several months. Correspondingly, as inflation data has remained below the Federal Reserve’s target, the Fed has been able to reverse course and cut interest rates three times in the second half of 2019 after having raised rates numerous times since late 2015. Additionally, while interest rate expectations are relatively volatile, the market currently expects approximately one more cut of 0.25% in the next twelve months. This has some investors wondering if fixed income is still an attractive asset class and do attractive opportunities still exist? The answer to both of the questions is still yes, if you have flexibility.
Why are we so confident that Fixed Income is and will remain an attractive asset class for our investors? Well, while we do not control interest rates or credit spreads (the two components of yield), we do control our security selection. Remember, at ACM, for private accounts over $300,000, we buy individual bonds and preferreds, and we generally do not have an investment mandate only to buy bonds or preferreds. Also, we don’t have to buy bonds within a certain maturity range, of a certain credit rating, or a specific coupon type such as fixed or floating rate (unless specifically restricted by the client). Simply put, we choose roughly 25-30 bonds or preferreds out of literally thousands and thousands of securities. This is surely achievable.
Achievable is defined as “able to be brought about or reached successfully.” There is no mention of the level of associated difficulty, but that is why you hire us. Selecting individual securities means ensuring we avoid many of the pitfalls associated with simply looking at a bond’s coupon, maturity date, and credit rating. For example, a bond’s coupon may be subject to change, a company may be able to redeem a bond before the maturity date, and credit ratings are always adjustable.
Choosing fixed income securities is challenging, and for clients the uniqueness of each security also makes understanding custodial statements challenging. When we select bonds and preferreds, we are targeting total expected return over the expected holding period. That period may differ from the maturity date, if these securities can be redeemed by the issuer. Therefore, thoroughly understanding the yield and duration of your Fixed Income portfolio by just reviewing your statements is typically not possible for the reasons discussed in the previous paragraph. These are the same reasons why, when we are choosing fixed income securities at ACM, we do not just look at a bond’s coupon and maturity to calculate yield. In order to help you better understand the differences between the economic returns and the statements let’s take a look at a few common examples.
If an investor owns a 6% coupon preferred at $26.50 that is likely to be redeemed in two years at $25.00, what is the yield or return? At first glance, an investor may think he or she is earning 6% for two years, but in reality the investor will only earn approximately 3% (2.9% to be precise). When one analyzes the cash flows, the large difference between the yield earned and the coupon payments received becomes more obvious. For example:
- Suppose an investors buys a preferred at $26.50 that has a coupon of 6%. He or she will receive $1.50 per year (6% * $25 = $1.50 dividend)
- If this preferred is redeemable by the company in two years at $25.00, what is the return?
- Outflow: $26.50 purchase price
- Inflows: $1.50 per year * 2 years = $3.00 + $25.00 at redemption = $28.00
- Total return is $1.50, or $0.75 per year, versus a purchase price of $26.50, which yields an annual return of approximately 3% (2.9% to be precise)
- Some Investors think they are paying $26.50 (equivalent to $106 bond price) to receive 6% or $1.50 per year forever, but this is typically not the case if the preferred is redeemable
The example above demonstrates why investors need to focus on returns rather than coupons. This above scenario is quite common given the large interest rate declines over the past decade. In a more extreme example, if the investor bought that preferred at $28.00, the return would actually be 0%. A $28.00 price generates two years of interest ($1.50 for 2 years = $3.00) plus the $25.00 to be received at maturity. This example may sound very extreme, but all too often passive retail investors own very high coupon, very low yielding securities. The same logic discussed above is also very common with bonds, as many bonds trade well above their par value (typically $100.00) and offer investors a significantly lower yield than the current coupon rate.
Calculating a return on a Fixed Income portfolio also involves avoiding two other common misunderstandings investors encounter. First, investors sometimes think they are losing money when they have actually made the originally expected return we envisioned when the bond was purchased.
To illustrate the first misunderstanding, we use an example of buying a 6% bond at $104 that matures in 2 years:
- Outflows: $104 purchase price
- Inflows: $6 * 2 years = $12 + $100 at maturity = $112
- The return is $112-$104 = $8, which is $4 per year or almost 4% ($4/$104)
- One year after purchase, if rates or credit spreads have not changed, the bond will only be worth $102 because you’ve already received one year’s worth of coupons:
- With one year remaining, the inflows are $6 + $100 = $106, so to earn that same roughly 4% return the investors would only be willing to pay ~$102
- Since the bond price declined from $104 to $102, your statement will show a “loss.” But the investment is working out just as expected (you made approximately 4% in year 1)
The second common misunderstanding arises because the investor’s statement balance underestimates the full market value of the fixed income account. This discrepancy is caused because the account value (in larger font) on the front page of your statement does not include the accrued interest on bonds. Accrued interest is the interest earned since the last interest payment was made. Bonds typically pay interest (coupons) twice a year—for example on January 1st and July 1st—so a 4% coupon bond would pay 2% interest on both January 1st and July 1st. Most often our purchases do not coincide perfectly with those dates. So if a bond appears in your account on April 1st, how much are you really paying to own the bond? (same math applies if you sell the bond)
- Outflows: $100 purchase price + the accrued interest for the 3 months the seller earned from owning the bond from January 1st thru April 1st which equals 4% * ¼ of the year, or 1%
- Therefore, you actually must pay $101 ($100+1) to buy the bond on April 1st because on July 1st you will receive $2 ($4 * ½ year = $2)
- $2 = ½ year’s worth of interest, but you only owned the bond for ¼ of the year so you only earn $1 of interest for the period April 1st through July 1st
We continue to find fixed income attractive as both a source of stability and an asset class capable of generating moderate returns in excess of inflation. Given the current fixed income market dynamics, we remain focused on keeping the quality of holdings relatively high as credit spreads (the risk premium above the corresponding Treasury bond) remain very tight. Regarding interest rates, we do not see the Fed likely raising rates in near term although the 10-year Treasury bond will likely continue to be volatile. We have recently raised duration from very low to a more moderate level given the current interest outlook. We do not believe now is a time to reach for additional yield, but we remain ready to pounce when opportunities do present themselves.