The fixed income sell-off that began in May — due to stronger-than-expected economic data — accelerated dramatically after Federal Reserve Chairman Ben Bernanke revealed details on the likely timing of Quantitative Easing's (QE) withdrawal. Over the following weeks, virtually all fixed income sectors sold off — even ones that have historically been “safe havens” from rising interest rates. Since June, some fixed income asset classes have bounced at least part of the way back.
So the question is: what was the lesson learned? Are investors exposed to too much fixed income or just the wrong fixed income? To answer that question, let's look at whether the typical refuges in a rising rate environment are still “safe”
Short duration investment-grade corporate bonds: Is there anything left?
The investment-grade corporate credit market has been one of the primary beneficiaries of the search for yield in the short duration space. Spreads have dramatically compressed since 2009 as business fundamentals improved and corporate chieftains focused on de-risking their balance sheets. However, accelerating share buy-backs — many funded by re-levering balance sheets —suggest equity investors are getting more attention these days.
Additionally, the sector that we believe has provided some of the best risk/reward in recent years — bank and finance paper — is now trading on top of industrial and utility yields after having traded wide for the last four years. With average spreads in the 1-5 year of the high grade corporate credit of ~90bp (over the comparable Treasury) we think investors have to be cautious in this part of the credit universe.
High yield: A “crowded” trade
The quick “snap-back” in the high yield market suggests to us that investors may be focusing on the positives — the high relative yields and low defaults. As most investors are aware, the attractiveness of high yield is highly dependent on default expectations. Defaults are the direct result of rising interest rates that force a downturn in the business cycle, creating difficulties for highly levered companies. Ironically, the slow recovery in the U.S. has created a very attractive environment for high yield because the Fed hasn't had to increase the Fed funds rate. Thus, it's likely that we'll be in a low default rate environment for some time to come. Given this, we believe spreads adequately compensate investors for the risk of this asset class — but we don't expect further dramatic spread compression.
Bank loans: Paying too much for interest rate protection?
The yield on bank loans is typically below that for a comparably rated high yield investment. In return for a lower yield, investors get two things: 1) security, and therefore better capital preservation and 2) greater protection from rapidly rising interest rates since loan coupons are reset quarterly. Thus bank loans typically perform better than other below-investment grade fixed income asset classes in times of rapidly rising rates or deteriorating credit conditions.
At this point in the cycle, they are providing “psychological” protection — insurance, if you will —for investors in the event that they are wrong about the timing of rising Fed fund rates. For us, bank loans remain an attractive asset class but we are monitoring the cost of this “insurance” closely.
Non-agency mortgages: A bet on housing?
Non-agency mortgage-back securities, formerly known as “subprime” instruments, have been a strong source of return since their meltdown in 2008/2009. Contributing factors include shrinking supply, reflating house prices, and the hunt for protection from the possibility of rising interest rates (as these are largely floating rate securities). We continue to believe that non-agency mortgages can provide decent return potential but the opportunity for dramatic out-performance is limited.
Thinking outside the box
While many of the historically sought “safe-haven” fixed income sectors in a rising rate environment may still be capable of providing some degree of cover, the degree of protection has diminished. Ultimately, we believe investors should seek out money managers that are cognizant of the twin risks of duration and credit, are mindful that the greater, more looming risk is duration, but who can adjust their portfolios over the next several years to this shifting landscape. Investors should have their fixed income allocation in nimble strategies that are not tied to a specific “box.”
Michael Temple is senior vice president and director of credit research, U.S., at Pioneer Investments.