Rethinking Fixed Income:

Transcription

1 Rethinking Fixed Income: The Importance of Income and Flexibility January 2011 Executive Summary Over the past 30 years, fixed-income investors have benefited from one of the largest secular trends in the investment world: the decline in yields of U.S. Treasury securities. This decline, from mid-teen levels during the early 80s, was a boon for bond investors, as it provided tremendous capital appreciation in addition to the interest income received. In the current interest rate environment, capital appreciation opportunities from declining interest rates will likely be limited for most bonds, as interest rates have approached the natural bound of 0%. From a bond investor s perspective, this highlights the importance of interest income as a more significant driver of bond returns. Additionally, the potential negative impacts from rising interest rates are heightened as many investors have been forced to extend portfolio duration in an effort to capture incremental yield. This reach for yield is being done in the face of upward pressure on interest rates from increased government supply. Thus, having an investment with the flexibility to respond to potential volatile interest rate movements and market environments is critical. Given this, we believe core fixed-income portfolios should be anchored with instruments that provide incremental income. Although investors will debate when and to what extent the level of interest rates will move, in these times, it is also important to have a great degree of flexibility to navigate risks from potential rising interest rates. This paper seeks to highlight various fixed-income asset classes as part of a fixed-income portfolio built around incremental income and flexibility. Key Concepts The importance of income as a driver of return will increase as interest rates have approached historic lows. In such a scenario, fixed-income portfolios should be anchored by instruments providing incremental yield, or spread. The potential to deliver incremental income, and hence returns, is likely achieved with an emphasis on investment-grade corporate debt. Investing in high-yield companies can enhance the income potential of a core fixed-income portfolio, thus providing the opportunity for stronger risk-adjusted returns. Senior floating rate loans are attractive as both an income driver and hedge against rising interest rates. A core fixed-income portfolio should have the flexibility to capitalize on this asset class. Although corporate debt instruments can provide higher levels of income and greater flexibility relative to most government securities, investors are taking on other types of risks, such as credit risk, which can lead to increased volatility. 1 of 11

2 Why Income Matters In general terms, the total return of a bond over a period of time is the interest, or coupon payment received, plus the change in price. For most investment-grade bonds, the largest determinant of changes in bond prices is the movement in interest rates. Since prices are inversely related to interest rates, bonds typically benefit when interest rates decline. The graph below illustrates the yield of a 10-year U.S. Treasury bond over the course of the past three decades. Yield on the 10-year U.S. Treasury bond, which was at one time over 15%, has now hovered under 3.5% for the better part of Since the yield of U.S. Treasuries is commonly used as the base for the general interest rate environment, the yields of most bonds have followed a similar decline over this time period. For most bonds, this decline in rates added tremendous amounts of capital appreciation on top of the interest income received. 30-Year History of 10-Year U.S. Treasury Bond Yield 20% 15% Yield 10% 5% 0% Source: Barclays Capital, October 1980 October of 11

3 In a low interest rate environment, the potential benefit to bond investors from a further decline in interest rates is limited. As the graph below illustrates, the decline in rates experienced over the past 10 years has now left little room for rates to drop further. As the chart starkly illustrates, an investor who purchases a 2-year Treasury note in October 2010 would earn less than $8.50 in interest on a $1,000 investment if held to maturity. With rates at such low absolute levels, the ability to generate additional income becomes of greater importance. Table of U.S. Treasury Yield Curve Yield Yield Curve 2010 Yield Curve month 6 month 1 year 2 years 3 years 5 years 7 years 10 years Maturity 20 years 30 years Source: Bloomberg, 9/30/00 and 9/30/10. For many bond investors, the simplest method to increase yield is to extend the maturity. However, this trade-off of increasing maturity for income has become more difficult to ignore, yet more dangerous to execute. For example, in 2000, an investor sitting in short-term instruments (less than 2 years in maturity) received interest income of more than 5%. By moving to a bond with a 10-year maturity, the interest would have increased by approximately 1%. In other words, the income opportunity lost from staying in short-term instruments was small on an absolute and relative level. Currently, with short-term instruments yielding less than 0.50%, an investor must purchase U.S. Treasury securities with a maturity of longer than four years in order to receive interest income of greater than 1%, and seven years for interest of greater than 2%. Although these levels may seem low, the interest income received as a result of extending maturity is not only greater on an absolute basis, but is significantly greater on a relative basis as yield can more than triple. However, with this reach for yield comes greater risk, as longer-maturity bonds typically have longer duration, thus exposing investors to increased volatility with interest rate movements. It is difficult to predict how, and to what extent, interest rates will move. However, with rates at low absolute levels, capital appreciation from declining interest rates is limited. Additionally, the potential negative impact from rising interest rates is increasing via a growing federal deficit and actions by the Federal Reserve attempting to reflate the Bonds 101 Duration can play a key role in bond investing. Generally, the farther out in the future a bond is expected to generate cash flow, the longer the duration of the bond. The opposite is true with a shorter duration bond. All else being equal, as interest rates fall, longer duration bonds appreciate more in price than shorter duration bonds. Conversely, if interest rates rise, the price of higher duration bonds fall farther. Therefore, in a rising interest rate environment, bond investors may prefer to hold shorter duration investments. domestic economy. Given these dynamics, the capital appreciation tailwind from declining interest rates could fade, and possibly turn into a headwind for bond returns. Hence, the importance of interest income in driving bond returns will be more important going forward. In such a scenario, incremental return for fixed-income portfolios will most likely be driven with a focus on incremental yield, or spread-based instruments. 3 of 11

4 In Search of Incremental Yield The most widely recognized universe for investment-grade bonds is the Barclays Capital U.S. Aggregate Index ( Barclays Aggregate Index ). This index has been used as the primary benchmark against which most fixed-income portfolios are measured. As a result, this has a large influence in the way many core fixed-income portfolios allocate assets. We define core fixed-income portfolios as those with at least 80% of their assets invested in debt instruments, possess an overall portfolio credit quality of investment grade, and with an intermediate-term average maturity or duration. The Index is comprised of four primary sectors: U.S. Treasury: Public obligations of the U.S. Treasury with a maturity of one year or more. U.S. Agencies: This sector is composed of publicly issued debt of U.S. government agencies, quasi-federal corporations, and corporate or foreign debt guaranteed by the U.S. government. The largest issuers are Fannie Mae (FNMA), Freddie Mac (FHLMC), and the Federal Home Loan Bank System (FHLB). Securitized: Mortgage-backed securities are more than 90% of the securitized sector as defined by Barclays Capital. These securities cover the mortgage-backed pass-through instruments of Ginnie Mae (GNMA), Fannie Mae (FNMA), and Freddie Mac (FHLMC). The remaining components of the Securitized sector are commercialmortage-backed securities (CMBS) and asset-backed securities (ABS). Sector Allocations: Barclays Capital U.S. Aggregate Index As of 9/30/10 Securi zed 35.8% Credit 22.2% U.S. Treasury 33.4% U.S. Agencies 8.6% Source: Barclays Capital, 9/30/10. Credit: More than 80% of this sector is publicly issued U.S. corporate debentures. The corporate debt sectors are Industrial, Utility, and Finance, which include both U.S. and non-u.s. corporations. There are also components of Sovereign, Supranational, Foreign Agency, and Foreign Local Government debt. The financial crisis of 2008 had significant structural impacts on the characteristics of these sectors. Increasing budget deficits have resulted in an increase in supply of U.S. Treasuries. In addition, government support of the mortgage-backed market, which forms the majority of the Securitized sector, led to a further reduction in overall investment-grade yields. By the end of September 2010, the yield of the Barclays Aggregate Index sat at 2.6%, a historic low. With new issuance of mortgages backed by the U.S. government expected to continue, the universe of investment-grade securities is now predominantly government-related securities. This government-related sector of the bond universe now represents more than 70% of the Barclays Aggregate Index. Government-related securities typically offer among the lowest yields, leaving traditional Barclays Aggregate Index-based portfolios with limited income potential. So where can investors seeking incremental yield go? When viewing the remaining composition of the index, the Credit sector stands out as a provider of meaningful incremental yield, making this sector the most likely contributor to additional returns in a fixed-income portfolio going forward. 4 of 11

5 The option adjusted spread (OAS) that corporate debt, the major component of the Credit sector, offers over U.S. Treasuries primarily compensates investors for the risk that the underlying company may default on its obligation. This spread provides two main benefits to investors seeking yield: higher current income should rates stay level, and a cushion against the potential negative impacts of an increase in Treasury rates. Additionally, during times of stronger economic activity, the fundamental performance of companies generally improves, which can result in lower default risk and subsequently lower spreads over Treasuries. This tightening effect on spreads provides the potential for capital appreciation, a feature that is limited in government securities. Option Adjusted Spread, or Incremental Yield, above U.S. Treasuries 200 Bonds 201 OAS is an indication of incremental income, or spread, added in basis points to the interest rate of a U.S. Treasury security. A larger OAS implies a greater return for a given level of risk. The OAS primarily compensates the bond holder for default risk, as well as the option to prepay the principal of a particular bond. This prepayment option is commonly associated with mortgage-backed securities. 150 Basis Points U.S. Agencies Securi zed Corporate Source: Barclays Capital, 9/30/10. In a low interest rate environment, the power of compounding income increases in importance. Relative spreads, in relation to overall risk-free rates, become more significant to investors. The table below shows the OAS as a percentage of the yield on the U.S. Treasury portion of the Barclays Aggregate Index. Spread per Unit of Risk Free Rate* 9/30/07 9/30/10 U.S. Aggregate U.S. Treasury n/a n/a U.S. Agencies Corporate Securitized * OAS as a percentage of yield on the U.S. Treasury sector of the Barclays Aggregate Index. OAS incorporates both interest rate sensitivity and prepayment risk. Investment-grade corporate bonds typically provide more relative spread when compared to other major investment-grade sectors. Despite the compression in corporate spreads over the previous year, corporate bonds still provide more relative spread on September 30, 2010, than they did prior to the financial crisis in 2008, an argument that spreads may compress further. For fixed-income portfolios managed to the Barclays Aggregate Index, the risk/reward trade-off can be greatly enhanced with significant exposure to corporate debt. 5 of 11

6 Enhancing through High Yield Traditional investment-grade corporate bonds can anchor a core fixed-income portfolio by providing higher levels of income than government bonds during stable-rate environments and dampening sensitivity to rising rates. Adding exposure to high-yield bonds can further enhance a portfolio s income while also providing an opportunity to capture price appreciation. This benefit from high-yield bonds comes with greater risks as they are typically rated below-investment grade, resulting in greater price volatility than investment-grade instruments. Additionally, since core fixed-income portfolios generally have an overall credit quality of investment grade, the exposure to high-yield bonds should have limitations. Option Adjusted Spread, or Incremental Yield, Above U.S. Treasuries Basis Points U.S. Agencies Securitized Corporate High-Yield Source: Barclays Capital, 9/30/10. A key factor when adding high-yield bonds to a core fixed-income portfolio is the risk/reward trade-off. As shown below, BB-rated investments over the past 10 years have achieved better risk-adjusted returns relative to the broader high-yield universe. Thus, the inclusion of BB-rated high-yield issues may be able to provide attractive incremental income, especially in a low interest rate environment, without a significant increase in volatility. 10-Year Risk/Reward Profile 10% Annualized Return 8% 6% 4% 2% BB Loans BB HY B Loans US HY B HY CCC HY 0% 2% 4% 6% 8% 10% 12% 14% 16% 18% 20% -2% Annualized Vola lity S&P 500-4% Source: Barclays Capital, October 2000-September of 11

7 This risk/reward profile of BB-rated investments is driven by lower default rates relative to other areas of high yield and a higher level of returns over time when compared to the overall bond universe. Investing in BBs is compelling due to the fact that it has proven itself in both contracting and expanding economic cycles. Since many traditional fixed-income portfolios are restricted from buying high-yield instruments, the demand for high yield can be limited, creating an opportunity for those with the flexibility and expertise to invest. The flexibility to invest across the credit spectrum by allocating to BB/B-rated high-yield issues potentially leads to stronger risk-adjusted returns for core fixed-income portfolios. Flexibility with Floating Rate Loans For many fixed-income investors, the negative impact from rising interest rates is a prevailing concern. Although a secular rise in rates has not materialized over the last three decades, it is a legitimate risk looking forward. As mentioned earlier, the investment-grade bond universe is largely composed of fixed-rate government and corporate securities. Where fixedrate securities are concerned, a rising rate environment could result in capital loss of a security if sold prior to maturity. There is, however, a fixed-income asset class that not only provides spread income in a stable environment, but can actually benefit in the event interest rates rise. These instruments are senior secured floating rate bank loans, commonly known as floating rate loans. The attributes of these securities are extremely attractive today, and a fixed-income portfolio should have the flexibility to capitalize on this asset class. However, similar to high-yield bonds, floating rate loans are typically rated below investment grade, and should have some limitations when being added to a core fixed-income portfolio. Floating rate loans are instruments that are pegged to a reference rate, such as London Interbank Offer Rate (LIBOR), to which a specified interest rate spread is added. This spread compensates the investor for taking on additional liquidity and credit risks, relative to risk-free instruments. Often, the same companies that issue high-yield bonds also borrow using floating rate loans. Floating Rate Loan Key Attributes Characteristic Description Benefit Secured Loans are typically secured by assets such as real estate, equipment, inventory and receivables, as well as the capital stock of subsidiaries. Downside Protection The collateral from loans typically provides a higher recovery in the event of default. Senior to Bonds Floating Rate Coupon Lower Correlation Loans are structurally senior to unsecured bondholders and equity. Loans typically set the interest payments to a floating rate index, such as LIBOR, plus a spread. Loan returns have low correlations to many broad market fixed-income securities. Higher Recovery Rate Being the most senior of the capital structure allows the lender to be repaid first. Mitigates Interest Rate Volatility The floating rate coupon helps keep pace with the market in rising rate environments. Diversification The low correlation provides diversification, particularly in rising rate environments. Why are some of these attributes beneficial? Hedge against interest rate movements and inflation: The coupon payments on fixed-rate bonds remain static for the life of the bonds, regardless of interest rate movements in the market. The coupon payments for floating rate loans, however, may not be static; when short-term interest rates rise, coupon payments for floating rate loans also rise. This mitigates most of the interest rate volatility associated with traditional bonds. In addition, since interest rates are highly correlated with inflation, the floating nature of coupon payments can address some of the risk of diminished purchasing power associated with inflation. Potential for higher income: When interest rates are low, floating rate loans offer higher income than other lower-duration instruments because of the spread demanded of borrowers with lower than investment-grade credit ratings. Thus, investors earn income beyond prevailing U.S. Treasury interest rates. This incremental spread can result in a yield that is sometimes higher than long-term fixed-rate bonds. 7 of 11

8 Low correlation with other types of bonds: The unique characteristics of floating rate loans cause them to react to economic conditions differently than fixed-rate bonds, making them an ideal part of a diversification strategy. Performance for floating rate loans has typically had low correlation to performance for more traditional bonds. This means incorporating floating rate loans into core fixed-income portfolios may reduce volatility. Low Correlations with High-Quality Bonds 1.0 Senior floa ng rate bank loans correla on vs. other asset classes (9/30/00 9/30/10) Senior Floa ng Rate Bank Loans U.S. Treasury Bonds U.S. Investment- Grade Bonds Emerging Market Bonds S&P 500 High-Yield Bonds -0.5 Data represented by: Credit Suisse Leveraged Loan Index, Barclays Capital U.S. Treasury Index, Barclays Capital U.S. Credit Index, Barclays Capital Global EM Index, S&P 500 Index, Barclays Capital U.S. High Yield Index. Secured by Assets: Although floating rate loans usually have a credit rating of below investment grade, most are structurally senior to bonds in a borrower s capital structure and secured by some form of collateral. In the event of bankruptcy, secured floating rate loans must be repaid before bonds are repaid. For investors, this provides meaningful downside protection in the event the borrower is unable to fulfill its debt obligation. Borrower s Capital Structure The illustration on the right shows that floating rate loans are typically senior to all debt in the borrower s capital structure. The holders of loans have priority over the claims of most other creditors and, in theory, must be repaid in full before the claims of junior debt holders are satisfied. Seniority Loans Bonds Preferred Stock Common Stock 8 of 11

9 Although the benefits of floating rate loans are attractive as both an income driver and a hedge against rising interest rates, many large core fixed-income portfolios are unable to effectively incorporate this asset class for a variety of reasons: Size of market The size of the floating rate loan market is approximately $500 billion. This number pales in comparison to the U.S. investment-grade market, which is over $15 trillion. For many bond portfolios, the ability to meaningfully incorporate these loans in a fixed-income portfolio is extremely challenging. Expertise Due to the complexity of the debt structures that many issuing companies may have, the difficulty of researching loans is greater than that for most bonds. Having expertise in the nuances of loans and understanding capital structures is essential. Since most core fixed-income portfolios are driven by allocations to government-related securities, individual company research may play a secondary role. Historic investor demand Historically, as Treasury rates declined, fixed-rate bonds offered a more attractive return profile, thus limiting demand for floating rate loans. In an environment characterized by low absolute Treasury yields, the demand for floating rate instruments may grow due to their relative attractiveness versus fixed-rate bonds. Implementing strategies to effectively incorporate floating rate loans into a core fixed-income portfolio can be challenging, due in large part to the reasons provided. Investment managers who have the expertise, nimbleness, and necessary infrastructure to utilize this asset class can offer investors a core fixed-income portfolio with higher income potential and the flexibility to position for a rising rate environment. Conclusion Investment-grade bonds are now faced with relatively low absolute yields after a three-decade decline in interest rates. This leaves most traditional investment-grade bond portfolios with low current income and limited potential for capital appreciation opportunities. A fixed-income portfolio that could provide high levels of income with greater investment flexibility could benefit most bond investors in this low and potentially rising interest rate environment. For investors who desire income, the risk/reward profile of non-government-related investment-grade bonds appears attractive. For investors concerned about the potential negative impact from rising interest rates, the flexibility to meaningfully utilize high-yield bonds and floating rate loans may be an effective solution. To manage a portfolio incorporating these principals, an investment manager should have expertise across corporate debt, be nimble enough to allocate meaningfully, and have the necessary infrastructure to operate effectively. Defining Risks Nearly all investments carry risk, and bond investments and floating rate loans are exposed to some specific types of risk. Credit Risk Understandably, capturing incremental yield in corporate bonds results in taking on a certain level of credit risk. That is, corporate bonds do not have the backing of the government, and corporate issuers may find themselves unable to make interest or principal payments. On a structural level, the greatest risk to a fixed-income portfolio with a larger allocation to corporate bonds is another credit crisis similar to the one that occurred from Although the losses experienced in 2008 were largely gained back in 2009, corporate bonds experienced a significant amount of volatility relative to U.S. Treasury securities. In the case of some corporate defaults, if the issuer has posted collateral, then investors can seize the collateral. However, if the collateral itself declines in value, then investors may not fully recover their investments. Credit rating agencies assess the creditworthiness of issuers and their bonds, and assign rankings to them based on widely accepted scales; the highest ratings are AAA/Aaa. Those rated BBB-/Baa3 or above are investment-grade, and are viewed as less likely to experience default. Those rated BB/Ba1 or below are considered below-investment-grade, and compensate investors with a higher spread in exchange for taking on more credit risk; high-yield securities and floating rate loans typically fall into this category. 9 of 11

10 Interest Rate Risk Fixed-rate bonds of any credit rating, whether government or corporate, are sensitive to changes in interest rates. When interest rates rise, prices on fixed-rate bonds generally fall, and vice versa. The degree to which prices change is largely determined by a bond s coupon rate and length to maturity, and is usually expressed as a bond s duration. A higher coupon and shorter maturity tend to lessen a bond s sensitivity to interest rate movements, while a lower coupon and longer maturity tend to increase the sensitivity. In contrast to fixed-rate bonds, floating rate loans have coupons that adjust with short-term market interest rates. For this reason, floating rate loans tend to exhibit little sensitivity to changes in interest rates. Spread Risk The spread on corporate bonds and bank loans is largely determined by market demands and economic conditions. Changes in spread may cause the prices of these securities to rise or fall. Such changes are reflective of the premium demanded by investors for taking on credit risk, and are particularly important for valuing high-yield bonds and floating rate loans. Reinvestment Risk When investors receive income or principal payments from borrowers, they may choose to reinvest those proceeds into other bonds. However, it is possible for the interest rate environment to have changed during the investors holding period. In such a scenario, investors may be unable to reinvest those proceeds in bonds of similar characteristics at the same yield. This risk is most prevalent during periods of falling interest rates. Inflation Risk Investors who receive income from bond investments may experience erosion of their purchasing power during periods of inflation. Since most bonds typically pay a fixed rate of interest, investors receive the same income even if inflation causes prices of goods and services to increase. Inflation usually has less impact on investors who hold floating rate loans; their income is dependent on prevailing market interest rates, which typically adjust with inflation. However, investors who own fixed-rate bonds may be adversely affected by inflation. Portfolio Risk It is equally important to recognize the risks inherent in government-related securities. As previously mentioned, the government-related sector represents more than 70% of the Barclays Aggregate Index. The risk/reward trade-off can be more attractive in corporate bonds relative to government bonds in an environment where interest rates move higher. Due to the lack of the spread offered by government-related bonds, portfolios with heavy weightings to government-related sectors may be more negatively impacted by raising interest rates. 10 of 11

11 This material has been prepared by Pacific Asset Management, a division of Pacific Life Fund Advisors LLC (PLFA). PLFA is a subsidiary of Pacific Life Insurance Company and an affiliate of Pacific Select Distributors, Inc. This material is provided for educational purposes only and should not be construed as investment advice or an offer or solicitation to buy or sell securities or to engage in any trading or investment strategy. The opinions expressed are subject to change at any time due to changes in market or economic conditions and should not be construed as research or investment advice. Certain information in this report is based on information obtained from various sources that are believed to be reliable. Past performance does not guarantee future results. Indices are unmanaged, do not have expenses, and cannot be invested in directly. Indices Barclays Capital Global EM Index: The Barclays Capital Global Emerging Markets Index represents the union of the USD-denominated U.S. Emerging Markets Index and the predominately EUR-denominated Pan Euro Emerging Markets Index, covering emerging markets in the following regions: Americas, Europe, Middle East, Africa, and Asia. Barclays Capital U.S. Aggregate Index: The Barclays Capital U.S. Aggregate Index is an index that includes U.S. government, corporate, and mortgage-backed securities with maturities up to 30 years. Barclays Capital U.S. Credit Index: Publicly issued U.S. corporate and specified foreign debentures and secured notes that meet the specified maturity, liquidity, and quality requirements. To qualify, bonds must be SEC-registered. Barclays Capital U.S. High-Yield Bond Index: The Barclays Capital U.S. High-Yield Bond Index is an index that covers the U.S. dollar denominated, non-investment grade, fixed-rate taxable corporate bond market. Barclays Capital U.S. Treasury Index: Public obligations of the U.S. Treasury with a remaining maturity of one year or more. There are several exclusions such as U.S. Treasury Bills, special issues, STRIPS, and TIPS. Credit Suisse Leveraged Loan Index: The Credit Suisse Leveraged Loan Index is an index designed to mirror the investable universe of the U.S. dollar denominated leveraged loan market. S&P 500 Index: The S&P 500 Index is a market capitalization-weighted index of 500 companies in leading industries of the U.S. economy. W A 11 of 11