By Partner & Portfolio Managers, Kevin Strauss & Kevin Kelly
Interest rates have risen dramatically in 2022 causing volatility and price declines that many investors are simply not used to experiencing in their bond holdings. The good news is that yields on fixed income securities have not been this compelling in many years. This market has created opportunity for fixed income investors with varying risk tolerance levels and tax sensitivities. A 1-year Treasury bond yields nearly 4.25% while intermediate investment grade corporate bonds yield over 5.5%, and intermediate tax-free municipals yield approximately 3.5% (7% taxable equivalent for the highest tax bracket). Investors with excess cash should take action to capture this opportunity.
The past three years have felt somewhat like a rollercoaster ride in the markets as the economic disruption caused by Covid forced both the Federal Reserve (Fed) and the Federal Government to take steps to mitigate the impact on firms and households. The Fed proactively intervened by cutting interest rates and buying securities to help stabilize the financial markets, and the Fed succeeded. Additionally, the U.S. and governments worldwide aggressively took fiscal policy actions aimed at both protecting and stimulating their economies. However well intentioned, these arguably necessary actions are now having some very undesired repercussions. The spend happy American consumer combined with supply chain bottlenecks to cause high inflation. Then just as the Fed had plans to tighten monetary policy, Russia invaded Ukraine causing more inflation, most notably in energy and food prices. The combined effects of growing inflation concerns, a very tight labor market, and pending Fed rate hikes caused rates to dramatically rise in 2022. Rising rates and economic uncertainty caused yields to rise and consequently bond prices to fall substantially. 2022 has been challenging for fixed income investors with the average investment grade bond now down more than ~18%, and high yield bonds down ~13%. Note that an actively managed portfolio of fixed income at ACM is down substantially less because we took several steps to mitigate our interest and credit risk.
Corporate bond yields are as high as they have been since the global financial crisis. A 3-year, BBB- bond, which sits at the lower end of investment grade, yields nearly 6% versus less than 2% at the beginning of the year. This is an extremely compelling yield for an investment grade portfolio of individual securities which investors can hold until maturity/redemption. At ACM, we currently focus on offerings at the lower end of investment grade (BBB/BBB-) because these securities typically provide incremental yield for what we deem as marginally more risk. Default rates on BBB- tend to be lower over time and we take an active management approach to further mitigate such risk. For investors seeking additional safety and willing to accept a lower yield, ACM allows clients to choose to own only higher quality investment grade securities such as those rated at least BBB or A-.
Municipal bond yields are the most attractive they have been in many years. Shorter maturity yields have increased dramatically in just the past two months. As an example, A-rated municipal bonds with less than one year to maturity were yielding less than 1% on August 1st but today are yielding greater than 3%. That is a historic move higher in such a short period of time. This allows a client in the highest tax bracket in a state with high income tax rates to have a taxable equivalent yield of more than 6% in short term municipal bonds. That 6% compares to approximately 2.5% – 3.5%+ in money market and 1-year CD rates. As you can see, it really pays to move your cash from the bank over to a short- term portfolio of individual tax-free municipal bonds. As a reminder, ACM manages portfolios of individual tax-free municipal bonds in every state in the country. We focus on bonds that are rated A- or higher, regardless of insurance coverage, and bonds that are general obligations or essential services of a municipality. This is as high quality a strategy as is available in the marketplace. Intermediate to longer term bonds are now yielding in the 4% range so the taxable equivalent yield is around 8%. That is quite close to long term equity returns and these are available with significantly less risk and volatility. It has been a long time since we have been able to express the current attractiveness of high-quality municipal bonds as part of a client’s asset allocation.
While the year-to-date fixed income price declines have been painful, such an environment creates opportunity. An important feature of bonds, which every fixed investor must remember, is that they mature (assuming no default). This means that if a bond’s price drops, creating ‘paper losses,’ these will be recovered at maturity. In contrast, bond funds and ETFs often do not hold bonds through maturity (nor do they even have that option) so paper losses can become realized losses. This is precisely why at ACM we prefer to own individual securities: this allows bondholders to recover their paper losses and also to receive interest payments until maturity/redemption occurs. Moreover, we are maintaining a relatively short duration so that this return of principal happens much sooner than it does for the average investment grade corporate and municipal bonds. This faster return of principal allows us to reinvest the proceeds of those maturing bonds at prevailing market yields.
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.