March 31, 2021
While interest rates have risen sharply off last summer’s lows, they remain historically low. 10-Year U.S. Treasury Bond rates moved from 0.50% in July 2020 to 1.74% at quarter-end. Although rates are back to pre-pandemic levels, they remain below longer-term historical averages: 10-Year Treasury rates averaged 2.3% since the 2007-2009 Great Financial Recession and a whopping 5.8% from 1990-2007.
The Federal Reserve (the Fed) has committed to keeping the Federal Funds rate low for several years to help the U.S. recover from COVID-induced shutdowns. Short-term interest rates are highly correlated to the Funds rate, so they should stay low. Intermediate and longer-dated rates are driven by expectations for economic growth and inflation. The surge in rates since last summer reflected investors’ improving economic outlook after the government’s massive fiscal stimulus and the Fed’s monetary ease.
The massive fiscal and monetary stimulus enacted to-date should lead to a surge in GDP and a pickup in inflation this year and into the next. Once this stimulus works its way through the system, we expect growth to return to the 2.0% to 2.5% pace of the past few decades. This slow rate of growth is consistent with our aging U.S. work force. Since longer-dated interest rates are driven by multi-year expectations of growth and inflation, and we expect the pace of growth to begin moderating sometime in 2022, we believe rates will grind only a bit higher from today’s levels rather than continue their recent spikes.
Foreign and Institutional Demand for U.S. Bonds
Strong demand for U.S. bonds will keep a lid on interest rates, which are higher than those in most other developed countries. 10-Year German Bunds yield a negative 0.30% while Japanese government bonds yield only 0.09%. With the large yield pick-up offered by U.S. bonds, foreign buyers have shown strong demand, despite massive supply.
Insurance companies and pension funds may become large buyers of bonds if 10-year rates move north of 2%. These funds have become over-weighted to stocks after equities’ strong appreciation, leaving them underweighted the bonds needed to match long-dated liabilities. We expect they will become aggressive buyers if rates rise much further from today’s levels.
Lastly, the Fed can redirect its purchases to longer-dated bonds, although it would only do so if rates were impeding economic growth or the market became disorderly. With such strong potential demand for our bonds, it seems unlikely that rates will return to the high levels experienced over 20 years ago.
Diversification Still Crucial
Although interest rates may stay historically low, bonds remain a critical component for investment portfolios. Besides providing a stable source of income, bonds also provide an important source of diversification as their prices typically move inversely to stock prices. Thus, in periods of stock market weakness, bonds often appreciate, reducing the deterioration in portfolios’ total value. With historically-rich valuations across many asset classes, this diversification is particularly important. Additionally, the same factors keeping a lid on interest rates could dampen returns in other asset categories, making the comparison to the low yields less stark.
Investors seeking a higher level of income than available in today’s investment grade bond market need to understand the risks imbedded in pursuing such strategies. In the stock market, higher yielding (dividend) stocks are often considered less risky, defensive strategies. High dividends are generally issued by staid, low growth companies, without much capital gain potential. For bonds, on the other hand, there is a known redemption and scheduled coupon payments, so higher yields reflect elevated risk.
There are many types of risk inherent in owning bonds, including: interest rate, credit, structure, liquidity, and correlation to the stock market. One should understand which risks one is assuming when purchasing high income strategies and be aware of how they may impact total portfolio return potential.
Some higher income vehicles are sector hybrids and come with the higher volatility of stocks, such as preferred stocks and master limited partnerships. Closed-end funds offer more income through leverage. Other instruments offer higher yields as compensation for limited liquidity, like private debt and loans. Others have a nontraditional rate structure—such as floating rate Treasury Inflation Protected Securities (TIPS) or short floating rate notes—but these typically offer lower, not higher, yields. Investors can also boost income by buying longer-dated bonds. However, since we believe there are near-term upward pressures on rates, we are cautious about adding more interest rate risk.
With an outlook for strong economic growth, adding credit risk is an appealing way to boost income. A booming economy can lift the credit worthiness of companies and lower default rates. Although the nearterm credit outlook is positive, investment grade credit spreads (the yield spread over Treasuries) have become so compressed that there is not a lot of value unless one moves to the non-investment grade space. Short dated, non-investment grade bonds look particularly attractive since higher quality short rates, anchored by the Federal Funds rate, are ultra-low.
Non-Investment Grade Securities’ High Correlation to Stocks
Investors need to be aware that non-investment grade securities have a higher correlation to the stock market than investment grade bonds, so owning them reduces the diversification benefits offered by Treasuries and municipal bonds. Credit spreads are correlated to stock prices, so credit spreads widen and narrow along with stock prices. It is important to consider this when adding them to portfolios.
Considering Leveraged Loans
There is a segment of the non-investment grade bond market that seems particularly attractive currently, given the present economic outlook. Leveraged loans are commercial loans issued by banks and then syndicated (i.e., packaged and sold) to other banks and institutional investors. Besides offering a substantial pick up over Treasuries due to their lower ratings, they also offer a yield pickup due to their more limited liquidity. In addition, leveraged loans have a unique payment structure where their coupon rates float. They are issued at a spread to the London Interbank Offered Rate (LIBOR) so, as short rates rise, the income from these loans also rises.
This should be a profitable structure to own when the Fed eventually begins to increase its ultra-low Fed Funds rate. Additionally, because leveraged loans are secured, in the event of a corporate default, loan holders are paid first. After loan holders are paid, unsecured bond holders, such as traditional high yield or corporate bonds, will be paid, followed by stockholders. As such, loans have a higher recovery rate—the amount of principal and interest received back in the event of a default—than the other securities.
Adding a small, tactical position of leverage loans to a traditional investment grade bond portfolio not only diversifies an otherwise all-fixed-rate coupon structure, but also can boost income in today’s low-income world.