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Why the best offense is a good defense in bond portfolios

Today’s edition of On the Trading Desk® features a discussion about ways to buffer fixed-income portfolios from rising rates. I’m talking with Michael Schueller, Senior Portfolio Manager, Multi-Sector Fixed Income Plus and High Yield at Wells Fargo Asset Management (WFAM) Global Fixed Income.

http://on.wf.com/6126HL8EI

 

Laurie King: I’m Laurie King and you are listening to On the Trading Desk.

 

We’ll be talking about strategies for fixed-income portfolios. It’s a timely topic now because interest rates in the medium- and longer-term maturities are rising, while short-term rates are anchored near zero due to Federal Reserve (Fed) policies.

 

To discuss some ideas, I’m joined by Michael Schueller, Senior Portfolio Manager, Multi-Sector Fixed Income Plus and High Yield at Wells Fargo Asset Management to share his insights. Thanks for being here, Mike.

 

Mike Schueller: Thank you, Laurie. Happy to be here.

 

Laurie: Let’s start with interest rates. Now you and your team wrote back in December of 2020 that “better fundamentals in 2021 may prove a challenge for fixed-income investors if interest rates also normalize.” What’s been happening with interest rates, and what do you mean by normalizing?

 

Mike: Well, we had quite a ride in the last year with the 10-year Treasury troughing at 50 basis points on August 4 of 2020 driven by significant fear and uncertainty. Since then, it’s moved over 100 basis points higher.

 

At the same time, the Fed funds has remained anchored, as you mentioned in your intro, near 0%. This means we’ve experienced a bear steepening in the yield curve as long rates continue to rise while the front end remains anchored.

 

What we mean by normalizing is that, as I mentioned, that rally in rates last year was driven by fear and uncertainty. As that fear and uncertainty begins to abate, rates markets will now start discounting prospects for growth and inflation as they would normally.

 

Laurie: So what can you tell us about the fundamentals in the economy, and why do you think yields will continue to rise?

 

Mike: Well, the key to the fundamentals in the economy, of course, is to resolve the pandemic. And we’ve made significant progress in the U.S., given the relatively strong vaccine rollout.

 

We’ve also had, as many know, significant fiscal and monetary support in the last year with prospects of more fiscal support continuing and the Fed committed to running the market hot. The consumer is generally in really good shape, but not everybody is and so we expect authorities to continue to favor support.

 

And the last key area of support is pent-up demand. We’ve seen evidence of this already with bookings for cruise lines and airlines increasing significantly lately on the prospects of reopening.

So all of these things, we think, mean that we’re going to experience significant growth in the next year or 18 months.

 

Moving beyond just the U.S., though, and thinking about what we’re seeing globally, in Europe, case counts and lockdowns are concerning and will likely delay growth there. Things in Asia are definitely looking better, but there are signs that China is taking its foot off the gas to some extent. There are some concerns in the emerging markets where the pandemic continues and vaccine rollouts have been delayed. But overall, we are very optimistic about global growth in the next year, although it may proceed in fits and starts.

 

As a result, we do think there will be upward pressure on rates. We tend to take sort of a 6-month horizon as we look forward, and over that time period, we see a trend of between 1.5% and 2% on the 10-year. The key question, as we move through this 6-month outlook, is whether inflation is on the rise. We see signs that that may be possible, but we have not reached a conclusion on that at this point.

 

Laurie: So with this bear steepening of the yield curve that you’ve just described, what type of fixed-income strategies have outperformed?

 

Mike: As a result of the bear steepening of the yield curve, short-duration bond strategies and leveraged loan strategies have significantly outperformed long-duration bonds, which also have lower yields. For example, the Bloomberg Barclays 1-to-3 Year High-Yield Index, with an average duration of 1.4 years and yield-to-worst of 4.1%, generated a total return of 1.5% year-to-date as of February 28, 2021. By contrast, the U.S. Investment-Grade Corporate Debt Index with an average duration of 8.4 years and yield-to-worst of just 2.16% had a -2.98% total return over that same time period.

 

Laurie: That’s quite a difference. You’ve recently written in the March edition of Income Generator, which is the flagship publication here for our fixed-income strategies, and you made the case for short-term high yield. In a nutshell, why?

 

Mike: Well, we think that we’re really in the cyclical sweet spot. Credit fundamentals are improving as the economy strengthens, as we discussed earlier, and that’s supportive of spreads. At the same time, there is upward pressure on longer-duration Treasury yields also driven by that same economic strength.

 

The reason we think the short-duration high-yield space is in the sweet spot is that our shorter duration protects us from rising rates on the long end of the curve and the spread cushion provides a healthy yield pick-up compared to other fixed-income asset classes.

 

Laurie: And so when you talk about this spread cushion, that also helps protect purchasing power. Is that right?

 

Mike: It does help protect purchasing power and it also provides a cushion if rates increase in response to rising inflation expectations.

 

And rising rates is really the most tangible way for fixed-income investors to think about that impact of inflation. The spread cushion helps absorb some of that increase in rates and the shorter duration helps in a couple of other ways.

 

First, by muting the price impact of rate changes and second, by allowing investors to reinvest proceeds of maturing bonds at higher prevailing rates.

 

Laurie: And what do you see in terms of credit conditions? If it’s short-term high-yield, folks may be wondering why high-yield right now, so what are you seeing in terms of credit conditions? Is the trend improving?

 

Mike: As I mentioned earlier, the improving economy is a significant tailwind for high-yield issuer fundamentals, like revenues and cash flows. And the other key is that we think we’re still in the early stages of the recovery.

 

It’s also important to note that the high-yield new issue market has been wide open for the last six months or so, and that has allowed many companies to extend their maturities.

At the same time, there’s enough caution out there that many management teams are focused on reducing debt, which is also a significant positive for credit fundamentals.

 

We are watching for signs of froth, and we are seeing some signs of froth in the loan market, in particular. As active managers, though, we can steer clear of credits that we think are too aggressively levered.

 

Laurie: So what else should investors know about investing in short-term high-yield? Are all short-term high-yield strategies the same?

 

Mike: That’s a great question, and there really are wide variety of approaches to investing in the short-duration high-yield market.

 

The market hasn’t really coalesced around any one or two indexes as it has in other fixed-income sectors. For example, most of the large ETFs (exchange traded funds) in the space include a significant allocation to CCCs and as a result, they have a return in volatility profile that is similar to regular high-yield strategies.

 

Active strategies in the space run the gamut from very conservative to more aggressive with meaningful CCC weights.

 

Short-term high-yield investors are presumably looking to reduce volatility or they were just invest in a broad market high-yield strategy. The challenge for investors is really to find the right balance between enhancing income enough to justify moving into high-yield while at the same time limiting volatility compared to a broad market high-yield strategy.

 

Laurie: Now is the reason a lot of those that you mentioned have a large weighting of CCC, is that because that’s just representative of the index and they’re just index weighting or market cap weighting?

 

Mike: That’s correct. Most of the large ETFs seek to replicate an index that is just limited by duration, so it might be 1-to-5 or a 0-to-5-year high-yield index, and those indexes tend to carry a weighting in CCCs of between 10% and 15%. And so by definition, they will have to have a meaningful allocation to CCCs. And many active managers also have a significant weighting to the CCC portion of the high-yield market, as well, in an effort to enhance returns.

 

Laurie: And so let me ask you, with the time we have left, do you have any thoughts that you’d like to leave our listeners with?

 

Mike: Well, I do. I think that investors who are focused on enhancing income by investing in the short-term high-yield market are generally worried about limiting volatility. And the best way to limit volatility in the short-term high-yield space is through careful security selection.

 

Just shortening maturity really doesn’t reduce your volatility all that much compared to a broad market high-yield strategy. And the reason for that is that the key driver of risk in the high-yield market is default risk rather than duration risk.

 

We think that many high quality short-term high-yield bonds have risk profiles that are a lot more like investment-grade bonds, because the shorter time to maturity provides a clearer line of sight to how the company can refinance or repay bonds.

 

But a significant portion of the short duration high-yield market is reliant on high-yield new issue markets being open for low quality issuers. There are times like last spring or during the Great Financial Crisis where the high-yield markets are closed to all issuers. But typically these periods don’t last for very long, and it’s always the highest quality issuers who are the first to come to market following one of those periods.

 

By contrast, the window of opportunity for low quality issuers is much smaller, and so the risk of it being closed when a maturity hits is much higher. It’s why we think good credit work and security selection are absolutely required when you’re investing in short-duration high-yield.

 

Laurie: Well, thank you, Mike, for your insights about how to add income to a portfolio, and thanks very much for being with us today.

 

Mike: Thank you for having me, Laurie.

 

Laurie: That wraps up this episode of On the Trading Desk. If you’d like to read more market insights and investment perspectives from the investment teams at WFAM, you can find them at our AdvantageVoice® blog, as well as by visiting wellsfargoassetmanagement.com. That’s also where you’ll find the entire series of Income Generator publications, which discuss actionable investment ideas based on the challenges and opportunities that the current market environment presents.

 

To stay connected to On the Trading Desk and listen to past and future episodes of this program, you can subscribe to the podcast on iTunes, Stitcher, Overcast, or Google Podcasts. Until next time, I’m Laurie King; take care.

 

Disclosure

 

100 basis points equals 1.00%. The ratings indicated are from Standard & Poor’s, Moody’s Investors Service, and/or Fitch Ratings Ltd. Credit quality ratings: Credit quality ratings apply to underlying holdings of the fund and not the fund itself. Standard & Poor’s rates the credit worthiness of bonds from AAA (highest) to D (lowest). Ratings from A to CCC may be modified by the addition of a plus (+) or minus (-) sign to show relative standing within the rating categories. Moody’s rates the credit worthiness bonds from AAA (highest) to C (lowest). Ratings AA to B may be modified by the addition of a number 1 (highest) to 3 (lowest) to show relative standing within the ratings categories. Fitch rates the credit worthiness of bonds from AAA (highest) to D (lowest).

 

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