Is Your Fixed Income Working For You?
By Kevin Kelly, Partner / Portfolio Manager
The past several weeks have been extremely volatile, although a well-constructed fixed income portfolio continues to provide yield and stability. For context, the intermediate corporate bond index remained positive year-to-date throughout the extreme volatility in April. For investors who feel like the recent volatility in their portfolio is perhaps overwhelming or concerning, an allocation to fixed income may be a way to potentially lessen the volatility while staying invested. We continue to find intermediate investment grade bonds compelling with a yield of approximately 5%. For historical context, the intermediate corporate yield index averaged ~2.5% for the 10-year period ending 12/31/21 prior to the large interest rate increases in 2022. For those in high income tax brackets, specifically for their taxable accounts, municipal bonds provide a post-tax yield well in excess of 3% (or 5-6%+ tax equivalent). We do not think what constitutes a “well-constructed” fixed income portfolio is static over time, so we are strong believers in active management. Which securities are compelling in good times, in uncertain times, and in challenging times varies dramatically based on interest rates and credit spreads.
Our view of the relative attractiveness across the Treasury rate curve varies meaningfully over time. We do see potential downside in the Fed Funds rate (the overnight rate between banks controlled by the Fed) and short-term rates (0-3 years) given significant tariff and economic uncertainty. However, we continue to favor exposure to 3-7 year bonds as we want to lock-in some level of duration, because we think the 3-7 year Treasury curve could decline significantly in a mild or moderate recession. With interest rates still elevated versus the 10-year period prior to Covid, some investors may be tempted to lock-in interest rates for a much longer period. However, we would caution against such a positioning. On the long-end of the curve, 10- and 30-year Treasury yields may not decline substantially near-term given the large U.S. government debt, potentially fading foreign interest in U.S. government debt, continued forecasted annual government deficits, and tariff uncertainty. For context, the 10-year Treasury yield is approximately where it was before the U.S. Presidential election, and the 30-year Treasury is only up ~0.40%. (As a reminder yield = the risk-free interest rate defined by Treasuries + a credit spread which is the additional yield or risk premium earned on a bond in excess of comparable Treasuries).
The importance of quality was recently highlighted during the April sell-off. We have been writing for a while that credits spreads were tight and discipline was crucial. We entered the year positioned conservatively holding investment grade debt, as we’ve been for several years. We continue to feel good about the risk/reward in intermediate, investment grade bonds (1-10) with a strong focus on 3-7 years bonds. During times of market uncertainty, investment grade spreads don’t typically widen more than 0.50-1.00%, which minimizes the risk of losing money over a 12-month period due to credit spread widening. Regarding high yields spreads, we entered the year quite cautious, since spreads were near 25-year lows as of February 2025. The risk/reward just didn’t justify being overly exposed to high yield credits. In several strategies where we regularly own high yield, we entered 2025 with high yield allocations at the lowest level in several years. April’s volatility allowed us to opportunistically buy some high yield names we deem to be solid credits at very compelling prices. Now with both investment grade and high yield credit spreads a bit wider, we are assessing opportunities, but credit spreads still remain below 5- and 10-year averages, so we will remain disciplined. The best thing about active management is we are able to adjust our credit spread risk over time as the opportunity set changes.
We continue to find interesting opportunities in preferreds, which depending upon the structure, offer a varying amount of interest rate and credit spread risk. The preferred market can be compelling, since each security is unique and there is a massive bifurcation between fixed rate coupons and variable/floating rate coupons. Fixed rate coupon preferreds can sometimes be extremely attractive, but ACM has generally stayed away from most of them since early 2022, because of the massive downside tail risk associated. For example, if market forces raise yields from 5% to 6%, that would imply a nearly 17% decline in price. This is simply too much price risk to be wrong on long-term interest rates or credit spreads. Since early 2022, ACM has been focused on variable/floating rate preferreds, which have coupons that reset (over some time period) to the interest rate environment (if not redeemed), which provides protection against rising rates. Notably, variable rate preferreds, many of which are investment grade, have meaningfully outperformed intermediate investment grade bonds over the past three years and even outperformed high yield bonds.
We continue to find fixed income quite compelling in the current environment, especially given the elevated uncertainty and volatility. We can’t overly emphasize the importance of owning a well-constructed fixed income portfolio, because a poorly constructed portfolio, perhaps unnecessarily, made some investors nervous in April.
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.