U.S. credit markets closed a year of moderate volatility with general expectations akin to those widely held twelve months ago. A steadying domestic economy, declining unemployment rates, some moderate wage improvement, and low inflationary pressure once again prompted the Federal Open Market Committee (FOMC) to indicate the likelihood of multiple increases in their short-term interest rate targets over the next twelve to twenty-four months. A challenging situation for investors to ponder, you may say? Still, such expectations were indeed just as widely held a year ago, and yet there were absolutely no FOMC target changes until the very last scheduled Board meeting. As a result, even though the U.S. Treasury 10-year note traded in a one hundred basis point (1.00%) range in yield during 2016, this important domestic benchmark closed out the year remarkably unchanged: not quite a quarter of point (0.19%) higher than its close on December 31, 2015.
With nominal domestic interest rates remaining at historically low levels, U.S. credit market total returns for 2016 were generally positive, albeit slightly anemic. The Barclay’s Intermediate U.S. Government/Credit Index provided only 2.15% total return last year. Not all sectors, however, performed evenly. Even following a general pullback in the fourth quarter as the market adjusted for renewed expectations of greater monetary tightening ahead, the intermediate-term investment grade corporate sector earned 4.17% total return for the year, nearly twice that of similar-maturity government markets. Preferred securities, the long-time credit market performance leader, reacted to the possibility of the Federal Reserve “normalizing rates” over the next several years much more dramatically. Reversing the sizeable gains of the previous three quarters of 2016, preferred securities ended the year with only a 2.32% total return. This pullback in the preferred sector was, interestingly, only the fifth negative quarter of total performance out of the past twenty-four quarters since the credit market recovery which began in 2011.
Recent structural developments in the preferred stock markets have evolved to better meet the needs of borrowers and lenders – offering both potential benefits and drawbacks for investors. As part of a global search for yield, several preferred stock exchange-traded funds (ETFs) have grown so dramatically in size relative to total supply that extraordinary flows in and out of the sector have arguably caused temporary pricing distortions. This short-term price volatility, while taxing sometimes on investors’ nerves, also provides opportunities to rebalance allocations strategically to the sector. Another market development that has significantly affected the preferred stock market is a growing dependence by corporate treasurers in utilizing the new issue market of “hybrid” or “structured” preferreds. These instruments are more akin to traditional debentures in that they trade over-the-counter in $1,000 par units and have a unique coupon determination formulae whereby an attractive initial fixed rate can be replaced with an equally attractive floating rate if the issue is not called in full. This structure provides the investor with an attractive level of possible protection if interest rates in fact do rise over the near future, and as a result, structured preferreds have proven much less vulnerable to the prospect of interest rate hikes than fixed rate, $25 par offerings from the same issuers. Whereas the BofA Merrill Lynch Fixed Rate Preferred Index earned 2.32% last year, the similar index comprised largely of structured preferreds earned 5.21% last year.
Does anyone know to what degree or at what pace the FOMC will actually raise their short-term interest rate targets this year or next? We do not – and we remain fully committed to leaving such forecasting to speculators, opting instead for fully invested portfolios that seek the highest possible returns while absorbing the lowest levels of risk. In this regard, we face a question that frequently arises from investors in times such as these: Why buy bonds at all if rates are going to rise? In response, we point out the following nuances to fixed income investing:
- Time is money, which is to say that it can be very difficult to recoup the income sacrificed while sitting on the sidelines, even when an interest rate guess proves accurate
- Corporations’ expense obligations must be met regardless of the interest rate environment, in a constant, responsible manner that is not dictated by credit market swings
- Bond allocations diversify and steady investment portfolios during periods of economic and financial distress and uncertainty.
Or, it may be just as simple to remember that when investing in fixed income securities, bonds are bought most clearly for yield, not for price.
In the persistently low interest rate environment we have experienced over the past several years, we have consistently opted to protect principal in our Current Income Portfolio by structuring corporate bond maturities in a conservative manner. First, we have avoided utilizing the full ten-year maturity authorization in this environment, laddering instead mainly between one and eight years. Beyond that, we have maintained an ongoing concentration (about 30% of the portfolio) in diversified issues that mature in three years or less. When coupled with the preferred securities allocation, the portfolio has remained positioned to produce current income in excess of alternative savings vehicles, while retaining the equally important ability to increase these income levels when opportunities arose. Rather than recklessly pursuing the highest yields possible in the near-term, at the expense of more attractive opportunities over the long haul, the significant allocation to short-term bonds preserves the portfolio’s flexibility to increase current income generation if and when interest rates rise in the near future. We are pleased such opportunities are already presenting themselves in the manner our strategy anticipated, and we continue to apply our risk-conscious approach to seeking high income.
This information is intended solely to report on investment strategies and opportunities identified by Roosevelt. Opinions and estimates offered constitute our judgment and are subject to change without notice, as are statements of financial market trends, which are based on current market conditions. This material is not intended as an offer or solicitation to buy, hold or sell any financial instrument. References to specific securities and their issuers are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Please contact us at 646-452-6700 if there is any change in your financial situation, needs, goals or objectives, or if you wish to initiate any restrictions on the management of the account or modify existing restrictions, or if you would like to request a copy of our Code of Ethics. Our current disclosure statement is set forth on our Form ADV Part II, available for your review upon request, and on our website, www.rooseveltinvestments.com.