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When Rates Are Rising, Cast a Wide Net

Author: Jon Mackay
When Rates Are Rising, Cast a Wide Net

The common refrain you hear these days about US equity market performance is that it has been subpar and sluggish. The S&P 500 is up 1.2% in total return for the year to date (through June 30) and has struggled to generate upside momentum. Even more sluggish has been the bond market. The Barclays US Aggregate Bond Index, which comprises US Treasury, US government-agency, securitized and corporate bonds is a widely used fixed income benchmark, down 0.14% in year-to-date total return. What’s more, that is a nominal return; even with low inflation, the real return is well into negative territory.

Zeroing in on corporate bonds the picture isn’t much better. The return for the Citi US BIG Corporate Bond Index, a widely used benchmark for investment grade corporate bonds, is -0.81%. Rising US Treasury yields have taken a toll on all bonds and the yield curve has steepened. Yields on long-term bonds have risen more than yields on short-term bonds—which has put pressure on longer-maturity bonds. The other issue facing high-quality bonds has been widening spreads, or a larger gap between the yield on a corporate and that on a like-maturity Treasury. That’s largely a result of a flood of new issues, as companies rush to sell debt before interest rates rise further.

SHORTER DURATION. The few areas of the bond market that are doing well are more "equity like" than "bond like"—high yield bonds, leveraged loans, preferred stocks, convertible bonds and, to some degree, emerging market (EM)bonds—and that’s where fixed income investors need to look for help. What attributes do these asset classes exhibit that have allowed them to outperform? For starters, they’re shorter in maturity and in fixed income the longer the maturity, the more damage done by rising interest rates. For example, the Citi High Yield Market Index, which we use as a high yield benchmark, has an average duration of 4.3 years, while the investment grade corporate index has an average duration of 6.9 years. All else being equal, the high yield bond will outperform investment grade in a rising-rate environment.Higher coupon income—which is the case with high yield, preferreds and EM bonds—allows these asset classes to offset some degree of price decline with higher income. Leveraged loans offer a hedge against higher rates as the majority of these loans have floating coupons that are linked to LIBOR, which will rise as the Federal Reserve hikes rates—something fixed rate bonds don’t offer. Perhaps the most equity-like are convertible bonds. These bonds have lower coupons than if they were conventional bonds, but carry with them the right to convert the bond into equity at a price determined when the bonds are issued. Thus, if the underlying stock performs well, holders of converts have a chance to participate.

PORTFOLIO ADD-ONS. We believe these asset classes should not replace core, high-quality bond holdings, but should be considered as add-ons to portfolios. In our view, rates are likely to rise, albeit modestly, from current levels and, while we may not see the negative returns the bond market experienced in 2013, it is unlikely we will come anywhere near the positive returns the bond market registered in 2014. In fact, nominal returns may end the year barely above zero in traditional fixed income portfolios. In our view, increasing exposure to equity-like parts of the bond market is a way to generate both income and total returns in what is shaping up as a challenging year for fixed income.

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