By Portfolio Managers, Kevin Kelly & Kevin Strauss
A dramatic rise in interest rates, driven by inflation, Russia’s invasion of Ukraine, supply chain disruptions, and other factors has produced historically large losses in the bond market within a very short period of time. The average investment grade corporate bond has fallen about 15% thus far in 2022. So, it isn’t surprising that many investors are questioning their bond holdings, which failed to provide much support to their portfolios as stocks also fell sharply. Bonds can play that traditional role, despite these headwinds, if managed properly.
2022 has started off as the worst year in recent memory due to an abrupt increase in yields
Interest rates have risen substantially in 2022 due to high levels of inflation and the corresponding actions of the Federal Reserve to address such inflation. The yield on the 10-year Treasury, has more than doubled in 2022 from ~1.5% to over 3.2%, and the Federal Reserve raised its key policy tool, the overnight Federal Funds Rate, by 0.75% to 1.50%-1.75%. This was an unusually large move for a single meeting, but the Fed saw inflation (and inflation expectations) moving higher and decided to take more aggressive action. Additionally, the market is pricing in another ~2.25% of cumulative rate hikes, which would take the Fed Funds rate to over 3.75%, by February 2023. As always, the Fed remains data dependent and changes to the inflationary or economic outlook could significantly alter the Fed’s actions. And if this didn’t create enough challenges for fixed income investors, simultaneous with rates rising, credit spreads widened significantly on greater macroeconomic concerns caused by the remedies needed to combat high inflation, the invasion of Ukraine, and geopolitical uncertainty. The rapid rise in interest rates and the significant widening in credit spreads in 2022 has been unusually severe and lie behind the sharp declines in many areas of the fixed income market.
While the year-to-date fixed income price declines have been painful, such an environment creates opportunity. An important feature of bonds that 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 do not hold bonds through maturity (or even have the option to) so paper losses 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 bond. And given this rising-rate environment, that return of principal allows us to reinvest the proceeds of those maturing bonds at higher yields.
Municipal Bond update
The average investment-grade municipal bond is down 10% year to date, holding up better than the average corporate bond and preferred. ACM’s strategy focuses on A- or higher rated municipalities regardless of insurance coverage. We further focus on general obligation bonds backed by the full faith and credit and taxing authority as well as essential services revenue bonds, typically avoiding airports, housing developments, hospitals and sports and convention centers. We have proactively reduced duration in order to provide some protection in the portfolios against rising interest rates. That action combined with our high quality strategy has resulted in ACM muni bond client portfolios being down less than half of the average investment-grade muni bond. For those clients in relatively high-income-tax states, municipal bonds remain very attractive.
Importance and Benefits of Active Management
For the past 20 years, the fixed income market was relatively easy to navigate as interest rates tended to decline or only rise modestly. However, the fixed income environment has changed dramatically, and active management is required. For example, ACM has reduced duration, sold select longer-dated securities, utilized inflation protected securities, and reduced fixed coupon preferred exposure all for the purpose of protecting portfolio values in a rising rate environment. Given inflationary pressures and macroeconomic uncertainty, we think a portfolio of relatively short duration bonds provides an attractive risk/reward fixed portfolio. A low duration, investment grade portfolio helps keep your interest rate risk moderate while also limiting the amount of credit risk taken. Currently, such a portfolio can provide an attractive yield, at a lower risk than equities, while investors navigate a challenging inflationary environment.
Reminder: Interest rates on Treasury bonds and the Fed Funds rate are different concepts
Regarding interest rates, investors must remember that interest rates on Treasury bonds and the Fed Funds rate are not the same thing. Interest rates refer to the yields on U.S. Treasury bonds, which are the risk-free rates in the U.S. at various maturities. The Federal Reserve’s primary policy tool is the Federal Funds Rate, which is the overnight rate at which banks borrow and lend excess reserves. The current Fed Funds target rate is 1.50-1.75% while a 2-year Treasury bond now trades at a price corresponding to a yield of ~3.2%. The 2-Year Treasury yield is higher than the overnight Fed Funds rate because the market expects interest rates to rise over the next two years as the Fed raises the target for the Fed Funds Rate to combat inflation.
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.