In the bond world, the primary question is how fiscal policy, monetary policy, and economic growth will impact bond investments. Fortunately for bond investors, the primary driver of returns is unrelated to these topics: it is income. Of course, one must be wise in bond selection and is likely to be well-served by avoiding excess duration in the face of rising rates like we recently experienced. Regardless of monthly statement valuations, when bond investors own bonds until the call or maturity date, they earn the income and yield stated at the time of acquisition. Bond returns are “pre-contracted.” This should be a great comfort to investors and they would be well-advised to focus on that aspect of their fixed income portfolios.
The recent increases in rates and drop in bond valuations may feel large, yet in reality intermediate bond portfolios are only mildly down in value. This is in the face of November 2016 seeing the largest single monthly drop in valuations for fixed income since 2008 during the financial crisis. The most popular gauge of the bond market, the 10 year UST’s yield increased 54 bps from 1.83% on Nov. 1st, 2016 to 2.37% on Nov. 30th, 2016 (source: Bloomberg) and many sectors of the fixed-income market witnessed very large declines in value over the 18 trading days that made up the month. Extending out further, long term, low coupon par bonds were dealt huge blows over the past couple of months. For example, Norwood MA General Obligations issued at $99.79 on Jul. 28th, 2016 traded at $80.67 on Dec. 1st, 2016; a Maine regional school district bond issued at par on Sep. 1st, 2016 traded at $79.052 on Dec. 1st, 2016 (source: Bloomberg). High quality, high coupon, intermediate bonds avoided these volatile swings and bonds with these very particular structural attributes performed quite well in comparison. Client portfolios’ positioning is a testament to one of history’s great lines of wisdom: “Be fearful when others are greedy.”
The primary objective of municipal bond portfolios is to generate consistent income with reasonable duration/exposure to price sensitivity. The selection of “bond structure”, that is the coupon level and call/maturity dates, is equally important to the actual selection of the bond issuers. When yields were very low in the preceding several months, client portfolios’ defensive positioning targeted high coupons and intermediate durations of 3-5. Portfolios with these types of bonds far outperformed bonds with lower coupons, such as the aforementioned, even though the final maturities have been similar. By comparison, ultraconservative very short term high grade bonds fared best from a valuation standpoint over the past two months, but the paltry 1.00% and lower yields available over recent years should hardly have these buyers saying, “I told you so.” The strategy of owning solid credits offering higher coupon/higher cash flow and short calls demonstrates the defensive positioning in place in the face of the accurately perceived potential of higher rates.
High quality bonds have a long history of performing well on a total return basis because fixed income pays just that – fixed income. Despite monthly statement valuation, investors’ coupon payments continue and help recoup any temporary declines in value. It is a matter of time before a portfolio’s income offsets any price declines stemming from rates changes. Many portfolios have high coupons averaging 4-5% (depending on which strategy is employed, exempt or taxable) which could quickly make up for the recent changes in value. This “breakeven” period can be shortened further through additional sources of investment return: rates could decline from here and bonds earn roll-down return. The essential point is bondholders own individual bonds which can be held long-term, making monthly statement values less relevant to investment results than the important benefit of earning 4-5% annual cash flows.
Higher rates are a welcome opportunity. While the cost to those currently invested was a mild decline in values, the long-term advantage is far greater: bond cash flows and future investment savings can be invested into higher yielding portfolios, helping to better maintain clients’ cost of living standards and purchasing power. The inverse to the aforementioned historical line of wisdom is, of course, “Be greedy when others are fearful.” Now is a good time to convert cash and bond fund/ETF monies into individual bond holdings given the market remains attractively valued, particularly high grade municipal bonds. Maintaining and further investing in high coupon, short call, intermediate portfolios at a time when yields are materially higher is likely to reward investors over the next several years, particularly given the stellar credit strength provided by municipal bonds over the past several decades.
It is possible that the ten year treasury yield climbs further over the next 12-18 months. Given the high coupon, intermediate duration bonds in client portfolios, this is nothing to be feared. It is also possible rates remain at similar levels or go lower from here. The last Fed rate hike in December 2015 resulted in the 10 year treasury falling from 2.28% on Dec. 15th, 2015 to 1.97% on Mar. 15th, 2016; the 30 year treasury moved similarly from 3.00% on Dec. 15th, 2015 to 2.73% on Mar. 15th, 2016. Further, there is typically a natural counter to rates increases: rates may reach a level at which incremental bond buyers appear in the market, slowing or preventing further increases. Finally, one must always remember the critical role of high quality bonds in a complete portfolio: they traditionally act as a “safe haven” investment in times of market stress/volatility, for which the potential certainly exists in the coming months and years.
Today’s combination of excellent credit strength and attractive yields available in the high coupon, intermediate duration portion of the bond market remains a compelling value. The best approach in our estimation is to remind oneself of the most important attributes of bonds: income. Investors would be well served remembering the historical safety provided by investment grade fixed income and the multiple avenues of return provided by bonds. An environment that pays bond investors more today than they earned yesterday is a welcome outcome. The cost of today’s higher rates have been mild to well-positioned investors, yet the advantages should last for far longer.
Greg Lavine, CFA, CFP®
Past Performance is not indicative of future results.
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Gregory Lavine, CFA, CFP®, Vice President Fixed Income Investments
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