Despite the Federal Reserve Open Market Committee (FOMC) raising short-term interest rate targets, US investment grade fixed income markets held surprisingly steady so far this year. The 10-year US Treasury note remained stubbornly fixed between 2.13% and 2.67%. But even this 50 basis point (0.50%) range understates the actual stability of interest rates experienced year to date. The widely monitored 10-year note has actually traded consistently more tightly to the average yield of 2.35% during this time period than suggested by the daily highs and lows.
This persistent lack of volatility has tended to serve bond investors willing to venture beyond the limiting confines of broadly constructed indices with large allocations to US Treasuries and agencies. The higher nominal yields available on investment grade corporate bonds provide valuable enhanced income in static interest rate environments. Moreover, yield spreads between government and corporate bonds (both investment and non-investment grade) have tightened this year, further improving the performance of corporate bonds.
The US preferred securities market added to its performance run that began last quarter, dramatically reversing the substantial sell-off at the end of last year. The BofA Merrill Lynch Fixed Rate Preferred Securities Index returned 3.35% for the quarter, after returning 5.21% in the first quarter. Year-to-date, the 8.73% total return for the preferred securities market dwarfs both the intermediate-term investment grade corporate bond market and the broad market, as measured by the BofA Merrill Lynch 1-10 Year US Corporate Index (2.77%) and the Barclays Intermediate Government/Credit Index (1.73%), respectively. These are wide differences between intermediate-term benchmarks over very short time periods. How much longer can these advantageous forces persist for bond holders?
The attractiveness of preferred securities this year has been driven by several factors, including the lack of nominal interest rate volatility, the recent lack of new issuance, and the flattening of the yield curve. This rally in preferred securities, as overall investment grade credit markets have remained largely stagnant, is indicative of the independence that this asset class may at times demonstrate – and helps explain some of the higher available returns on preferreds relative to debentures of the same issuer. However, understanding the risk of short-term price volatility with preferred securities (for better or for worse) is necessary for optimal portfolio construction. As the FOMC continues on its path toward normalizing interest rates, we may see further volatility in the preferred market, making timing decisions difficult. As such, we believe a strategic long-term allocation to preferred securities is a valuable portfolio component – especially for income-oriented investors.
In the preferred securities market, fixed-to-floating rate structures are less dramatically impacted by changes to the slope of the yield curve, or narrowing of the difference between short-term and long-term interest rates. These hybrid issues have become a growing aspect of the preferred market and have been a recent favorite of corporate treasurers looking to diversify their overall debt structures. Assuming these securities are not called and their coupons convert into a floating rate, they should exhibit less negative price sensitivity in a rising interest rate environment. For this reason, we find this structure to be advantageous.
While we strongly believe that attempting to forecast interest rates remains a futile exercise, we find it fruitful to remain cognizant of current trends, reasonable expectations, and official Fed pronouncements. At present, we are operating under the assumption that interest rates are likely to trend higher, albeit slowly. Certainly, this forecast is in line with Federal Reserve Bank policymakers whose official guidance is to expect short-term interest rate targets to be increased over the next couple of years towards “normal” levels. It is also expected that the Fed’s future monetary policy will include a slow unwinding of holdings that it acquired as part of the quantitative easing policy carried out in the years following the credit crisis. When enacted, the return of securities to the marketplace from the Fed’s balance sheet will likely simultaneously work to raise interest rates along the US yield curve as supply is increased.
Our current strategy is therefore to 1) remain fully invested in a diversified portfolio of investment grade securities in order to boost current income levels; 2) transition our preferred securities allocation towards fixed-to-floating rate structures; and 3) retain our flexibility to take advantage of rising US interest rates as they potentially become available. In this manner, the Current Income Portfolio is positioned to seek attractive ongoing yields and benefit as expectations for higher nominal rates are realized.
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.