Following two quarters of strong performance, U.S. investment grade credit markets steadied in the third quarter. Domestic interest rates bottomed in June, with the U.S. 10-year Treasury hitting 1.40%. Since then, a number of economic reports, official speech-making, and policy indications from abroad have combined to push U.S. interest rates a bit higher. Nevertheless, they are still historically very low and remain well below the 2.20% 10-year levels seen at the beginning of the year. A global search for yield (and safety) continues to direct investors away from the uncertainties of the United Kingdom’s Brexit plans, potential Brexit ramifications on the Eurozone, and official policy retreat from negative interest rate targets – and directed investors toward U.S. credit markets, where positive returns and relative safety and stability can still be found. As a result, credit market performance over the past few months has been less robust than that experienced over the first half of the year, and may forewarn potential pressures building over the horizon.
The intermediate corporate market, as measured by the BofA ML 1-10 Year U.S. Corporate Index, earned 0.97% total return over the third quarter, consolidating robust earlier performance and totaling 6.18% year-to-date. As they have for much of the recent challenging environment, corporate bonds continued to remain more attractive than Treasury and agency sectors, with 1-10 year Treasury and agencies combined posting a -0.24% total return last quarter, and only 3.27% year-to-date, as measured by the BofA ML 1-10 Year U.S. Treasury & Agency Index. In the preferred securities market, current yields remain relatively attractive, in our view, and total returns were slightly better than those of intermediate corporate bonds. Preferred securities posted a 1.22% total return for the quarter, and 6.37% year-to-date, as measured by the BofA ML Fixed Rate Preferred Stock Index. Incidentally, this was the tenth out of the past eleven quarters of positive performance across the preferred securities sector.
In the corporate debt market, the finance sector recovered to some extent from earlier selling pressures related to international banking uncertainties and the Federal Open Market Committee (FOMC)’s delay in interest rate increases. We see some relative value in the banking sector, but it appears that higher interest rates will be required to further tighten these yield spreads. Indeed, the long-awaited further increase in short-term interest rate targets from 0.25% is still under consideration by the FOMC. Public announcements and personal indications by the Committee’s members suggest that rate rises will resume shortly, with perhaps the first move coming in December – to be followed by several more over the course of 2017 and early 2018. Such, at least, is the market’s expectation, and this anticipation of what may lay ahead for rates is priced into bonds currently.
A slow and steady return to interest rate normalcy, as termed by Federal Reserve officials, may offer a rather benign environment for fixed income investors. While current bond prices will have to adjust to reflect gradually rising interest rate levels, the passage of time over the years that these increases are expected to occur may provide a meaningful offset to the associated price changes, potentially even enabling positive total returns.
Longer maturity issues, of course, are considerably more exposed to short-term interest rate rises, and therefore to more severe potential market price deterioration. As a result, fixed income investors are now forced to balance the desire for the highest possible current yield with the desire for preservation of principal. Moreover, for income-oriented investors, the ability to take advantage of higher interest rate levels, if and when they become available, may become increasingly significant.
In an effort to balance these risks and objectives, here at Roosevelt we attempt to offset the price risk of rising interest rates by counterbalancing longer-maturity investments with shorter-maturity issues. These shorter-maturity issues are scheduled to potentially approach maturity just as the Federal Reserve is expected to provide higher (and more attractive) interest rate levels at which to reinvest. In fact, we believe this approach to seeking to stabilize market value while enhancing income flows over extended time periods will largely benefit from a rising rate environment.
Nevertheless, it’s important to note that underlying the scenario of a slow and steady normalization is the notion of controlled price inflation at or near the Federal Reserve’s 2% annual target. Should inflationary pressures gain more momentum than currently expected, interest rate increases may have to be accelerated. Similarly, decelerating pricing pressure may force the FOMC to delay anticipated rate hikes further into the future than now believed. We expect the path to normalcy to meander as new economic data suggesting the pace and extent of future rate rises is disseminated and absorbed by credit markets and policymakers. As experienced recently, no shortage of volatility should be expected as this transition occurs. Individual sectors will respond differently to the changing environment, both positively and negatively, and downturns and opportunities will present themselves. In this regard, we recognize the importance of active management in navigating a fickle fixed income landscape. Here at Roosevelt, we remain committed to our income strategy’s guiding philosophy: providing a sustainable and substantial income stream regardless of the market environment.
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.