Bond Investing in a Low Interest Rate Environment
The investing environment of the past few years has been the most challenging that US bond managers have experienced in decades. Rates approached historic lows and then continued to ratchet still lower over the past three years. The search for value has evolved into an exercise requiring considerable patience, perception, and analysis.
In recent months, market dialogue has focused on selling or reducing bond holdings and redeploying funds into stocks and other risk assets. Such dialogue did not provide much distinction between short, intermediate and long term bonds, each of which reacts differently to changes in interest rates and generates varying returns. Nor did such dialogue seem to incorporate many of the underlying reasons for which investors allocate to the fixed income sector.
Some Reasons for Allocations to Fixed Income:
- Preservation of capital
- Reduction of the volatility of an overall portfolio
- Generation of income
- Liquidity needs
- Other customized needs or goals
We believe that investment grade bonds continue to offer compensatory after-tax returns, even in the current low rate environment, and are an important and valuable asset class in their own right. While identifying relative value requires more research than previously, we believe that efforts to do so can be rewarding.
Fixed Income for the High Net Worth Individual: Identifying Value in the Municipal Bond Sector
Yield Curve: In order to mitigate volatility, Samson generally focuses most of its investing in bonds with final maturities inside of 10 years. The yield curve within the 1 to 10 year space is not a straight line; rather, it curves and that curve moves incrementally but meaningfully over time. Therefore, there are often areas which can be identified as representing better value. Shorter holdings (inside of 5 years) can offer relative value over an extended period of time, even if rates remain low. In its most recent announcement, the FOMC reaffirmed its decision to keep the target Federal Funds Rate at 0.0% to 0.25%; we believe this creates value in the five year and shorter area of the market where the curve is very steep.
Credit Spreads: At various points in time, a AA-rated bond will trade at a wider or tighter spread relative to a AAA-rated bond. Typically, those spreads are not constant, and there are times when a AA or A bond will represent better value than a AAA and vice versa. We determine value based on an analysis of market conditions and our own investment experience. In Exhibit 2, we show the current yield pickup an investor in AA bonds would receive over AAA bonds.
Sector Spreads: Municipal bonds are popularly depicted as fairly generic instruments, however they are quite varied in structure and financing purpose. In addition to General Obligation (GOs) bonds, which are backed by the taxing power of the state or municipality, and Revenue bonds, which may be supported by the revenue from a specific project, there are many subsectors. GOs may include bonds of states, cities, towns, villages, counties and school districts. Revenue bonds may include essential purpose bonds such as water and sewer, public power bonds, as well as transportation and healthcare, among many other sectors. Being able to distinguish between all of these subsectors, and having a solid understanding of how they generally trade, can allow us to identify advantageous buying opportunities
Taxables vs. Municipals: Imbalances and dissonance in the bond markets may lead to times when taxable securities offer comparable or better yields than tax-exempt bonds, even on an after tax basis. In Exhibit 3, above, we show the 5 and 10 year Municipal/Treasury ratios. In the not-too-distant past, these ratios were 70-80%. Today, one can buy a municipal at a ratio of 100% or more of the Treasury yield.
Defensively Positioned Portfolios: Because rates are historically low, it is important to (a) understand the factors which might allow rates to continue to be low, or which could change the scenario to one of rising rates and (b) position the portfolios to be more defensive than otherwise might be the case.
The Current Bond Market Weakness: Permanent Selloff or a Buying Opportunity?
A major factor in structuring a bond portfolio, in addition to the value determinants suggested above, is deciding average maturity and duration. A critical consideration is the anticipated direction of interest rates. A sell-off in financial markets may be an indication of worse things to come, or may present a buying opportunity, depending on outlook and the analysis of factors which contribute to that outlook. In our commentary of June 21st, “Municipal Bonds: Oversold and Undervalued,” we discussed whether the recent sharp selloff in bonds constituted a permanent change in the structure of interest rates or a temporary market dislocation that presented a buying opportunity. Our analysis concluded the latter.
In its most recent statement, which immediately preceded the current sell-off of both bonds and stocks, the Fed suggested that the economy would continue to grow at a “moderate” rate, unemployment would “gradually” decline, that it viewed the risks to the economy as having “diminished” since the fall, and that it expects inflation to run at or below 2%. Furthermore, to support a “stronger” economic recovery, and “to ensure that inflation, over time, is at the rate most consistent with its dual mandate,” the Fed will continue its bond buying at the standing rate of $85 billion per month.
In short, nothing major about ongoing Fed policy has changed for the moment. However, if economic growth picks up, the Fed will most likely taper and eventually end its quantitative easing program. The Fed has indicated that it may begin to reduce, or “taper,” its purchases of securities in September, provided economic growth achieves certain thresholds. Therefore, we should identify some of the salient factors which could portend an end to Fed buying and ultimately lead to sustained higher rates.
From the Fed’s June 19th press release, some signposts which may be indicative of sustained higher rates are:
- An unemployment rate which is moving lower; the Fed is now targeting 7.0% (formerly 6.5%), and unemployment is currently at 7.6%.
- Monthly job creation numbers consistently in excess of 200,000 per month for several months, currently around 165,000–175,000.
- An increase in per capita income growth, currently flat.
- Inflation at 2.5% or higher, currently around or below 2% and perhaps decelerating.
A sustained increase in economic activity, probably indicated by 2 consecutive quarters of GDP growth at or above 3%; current GDP growth has trended around 2%.
When Higher Rates Arrive: The gradual arrival of higher rates—at some point in the future—is something that can be welcomed by investors. As you will note from the chart below, the decrease in rates was not a direct decline. Although the long-term trend was downward, the path consisted of many up and down movements. The path back up is likely to be a similar zigzag, given the extraordinary conditions that led to today’s low rates. These higher rates may be indicative of a stronger, more vibrant, more self-sustaining economy than we have currently, an economy that will no longer need extraordinary and sustained central bank intervention to buttress it.
Additionally, a thoughtfully managed portfolio may be well positioned to take advantage of rising rates. Short maturity bonds (generally inside of 3 years), which now provide stability to the portfolio, but whose yields are low, can be sold to purchase longer bonds and lock in higher rates.
But in the interim—and this interim could be in several months, or even a few years—until higher rates arrive, a carefully managed, value-oriented, intermediate-term municipal bond portfolio may still provide value in and of itself, and add stability and counterbalance in the context of a larger portfolio incorporating riskier asset classes.
Carolyn N. Dolan
Joseph A. Abraham
July 3rd, 2013
Any statements regarding future events constitute only subjective views or beliefs, are not guarantees or projections of performance, should not be relied on, are subject to change due to a variety of factors, including fluctuating market conditions, and involve inherent risks and uncertainties, both general and specific, many of which cannot be predicted or quantified and are beyond our control. Future results could differ materially and no assurance is given that these statements are now or will prove to be accurate or complete in any way. Certain information herein was obtained from third party sources which we believe to be reliable, but Samson cannot guarantee the veracity of the information.