By Portfolio Managers, Kevin Strauss & Kevin Kelly
After a challenging 2022 for fixed income, the outlook is much brighter for 2023. The yields currently available provide attractive opportunities for investors of varying risk tolerances and tax sensitivities. While the Fed is expected to raise the overnight Federal Funds Rate, its key policy tool, any hikes will likely be smaller than in 2022, and then we expect the Fed will pause and observe the economic impacts. The other good news is that interest rates on Treasuries bonds, which drive corporate bond prices, already reflect these expectations. For these reasons, we are constructive on fixed income in 2023 because higher yields make positive returns more likely for portfolios with moderate duration (interest rate sensitivity). This is because the higher yields are expected to more than offset potential negative price impacts from Treasury rate increases.
Treasury bonds yield approximately 3.5-4.5% or better, while intermediate investment-grade corporate bonds yield around 5.0% or higher, near the highest levels since 2009. For tax sensitive investors, intermediate tax-free municipals yields are near 2.75% (5.5% taxable equivalent for the highest tax bracket). Additionally, the opportunity cost of sitting on cash is simply too high to justify. For existing fixed income investors, the opportunity to invest in higher yields came at a ‘cost’ last year, but fortunately for investors that own individual securities they only had ‘paper losses’ that should be recovered over time (assuming no defaults or sales). Remember, if a company pays the interest and par at maturity/redemption, then you earned the yield you expected when you purchased the bond.
2022 was tough for investment grade bonds, but now yields are near the highest levels since 2009
2022 was so challenging for fixed income because it was the perfect storm of rising interest rates, widening credit spreads, and geopolitical uncertainty caused by the invasion of Ukraine as well as increased tensions between the U.S. and China. High inflation forced the Fed and many other global central banks to begin aggressively tightening in order to preserve long-term economic stability. Monetary policy tightening led to heightened economic and recession fears that persist today among many investors. Unfortunately, for a large number of fixed income investors, especially many in bond funds and ETFs, 2022 came as a rude awakening to the extent of interest rate risk they were consciously or unknowingly taking. However, 2022 was a great opportunity for disciplined investment managers to demonstrate their ability to navigate challenging market conditions. Discerning security selection combined with moderate duration (interest rate risk) resulted in significant outperformance for ACM’s fixed income, versus the intermediate investment-grade corporate benchmark, which was down more than over 9%. But this compares to the average corporate investment-grade bond down nearly 16%. These performance variations highlight the importance of active management as market conditions evolve.
High yield bonds were not immune to 2022’s challenges. The average high-yield bond, which has a lower duration but substantially more credit risk than the average investment-grade bond, was down more than 11%. A large portion of this downside was avoided by ACM’s clients as a result of owning primarily shorter-dated high-yield securities, which have less interest rate and credit spread sensitivity.
The preferred market was where many investors got hurt significantly in 2022 if they did not carefully choose their securities. The cost of being wrong is simply much higher in preferreds as they typically do not mature or they mature after an extremely long period. This means investors cannot simply choose to hold for a relatively short time period until redemption/maturity to recover their paper losses. Investors who bought fixed rate preferreds with coupons below 5% fared the worst last year. ACM was very careful to avoid such securities as we deemed the risk to far exceed the potential reward. Security selection was crucial in 2022 as the variation in performance among preferred securities by the same issuer in some cases exceeded 20%. We have written in the past that, generally speaking, no two preferreds are identical, even if they have the same issuer. The good news for preferred investors is that many other preferreds have variable coupons, which adjust to the interest rate environment over time. Therefore, if investors choose securities with attractive credit spreads, they generally only have about 5, 7, or 10 years of interest rate risk post issuance. We are currently finding very attractive variable preferreds, and because the preferred market is so inefficient, we continue to find an allocation to such preferreds compelling.
Looking forward to 2023, ACM is constructive on fixed income because the relatively high yields in the market provide a large buffer to potential rate increases and this makes it more likely they will generate positive full year returns. This outlook depends crucially on the creation of a fixed income portfolio characterized by moderate duration risk, disciplined credit risk, and thoughtful security selection. With individual securities, investors can choose to hold until redemption, which would allow any paper losses to be recovered so that the yield earned equals the yield estimated when purchased (assuming no sale or default). This is typically not an option in bond funds and ETFs. Furthermore, investors have the opportunity to lock in higher yields than have been available for some time. If interest rates were to decline, investors would have paper gains that could be monetized if they were to sell their bonds prior to maturity/redemption. We strongly encourage investors swap their excess cash for fixed-income. Cash falls in real value because of inflation, and current opportunities available in fixed income provide material income.
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.