This article is intended to provide portfolio managers and investment committees some initial guidance with respect to the difficult interest rate environment with the only apparent solution being a decrease in credit quality.
Duration - The interest rate risk for fixed income securities. For example, a duration of 4 would mean that if interest rates rise by 1% or 100 basis points the value of the security will move by approximately 4%. It is one of two main risks and potential sources of return for fixed income instruments.
Credit risk - Generally the inability of a bond to pay interest in the case of default or for decline in credit quality to cause yields to rise.
Duration has been a powerful tailwind for many debt classes over the last year. TLT, the I-Share 20yr plus ETF, has provided a return well in excess of 20%. That return demonstrates the power of the Treasury rally based in part on a flight to quality.
Credit has not fared as well with high yield generally providing a flat to negative return depending on the fund while investment grade debt gave investors a return of approximately 6%.
In relative terms it has been a worse bet to pare back duration and increase the risk of the credit portfolio. As we move forward in an environment of reasonably robust corporate cash flow coupled with massive macro headwinds in Europe, duration and credit can both be held prudently in a portfolio.
How the world unfolds for the remainder of the year will determine what slices of the credit and duration world succeed. Let's take a look a future that involves a continued modest slowdown in the largest EM country, China, European political and economic inertia and reasonable but slowing and below trend growth in the US.
The Treasury market is a massive liquid voting machine and right now it is collectively more worried about the European debt issues over potential inflation here in the US, in effect buying negative yields. They believe that duration is a more prudent investment given the European debt issues that will remain a potential problem for at least the remainder of the year. There are simply too many banks and sovereigns with credit issues for it to be solved overnight.
This gives me a decent amount of confidence that duration will not be abandoned en masse unless there is an unanticipated spike in inflation and an inflation premium is assigned to the yield curves globally. While I will complete a different piece on inflation, I will offer that inflation will not be a major risk over the rest of the year. Still, getting a negative real yield is not too appealing for an investor.
As mentioned, credit and duration are the answer but only when working together. If I focus on the US market I can garner a positive real yield by investing in TLT (I-Share 20+year Treasury) at over 3%. So I am barely positive with a CPI of 2.7%. That is not much carry for a duration of close to 8. That bet only works if the three factors mentioned above deteriorate in the months ahead. That is the pure duration bet and while the credit quality of the US Government is a risk with that placement, it is on the back burner for now.
Credit exposure also gives an investor the chance to garner real yield assuming CPI is accurate at 2.7%. Here the carry opportunities are more apparent as investment grade debt is around 3-5% depending on the funds quality and duration, while high yield is in the 7% range. Here is the dilemma. Investment grade has been propelled in part by solid cash flow generation and duration. If both weaken, then the trade unwinds significantly. For instance, LQD is generating a yield of approximately 3.45% with a duration of 7. That is not a risk to reward that I believe is appropriate. The investor is only receiving 60 basis point of real yield in the hope that the 7 duration does not work against them. Sell and take your profits if you have a position - we do not recommend a new placement at this time with a broad based ETF investment grade product.
The I-Share ELD is one that represents to various weights the EM local currency index. It is largely advocated as a diversification tool. It does provide an investor with a different risk to reward profile, however, it does guarantee an enhanced optimized allocation.
In this case the 4.42% yield provided by this ETF comes with a hefty 7.37 duration. That is massive interest risk for a modest 4 or so yield. If the EM world were in an upsurge and immune to global macro risks that might be advisable. However, even though the EM world has matured, it remains to some degree a simple risk off trade sale candidate when there are global concerns. The duration that allows for a strong upside when EM risk is bid up works in reverse in a decelerating world economy and heightened European risks. The duration portion could lend support as many foreign central banks are in ease mode, however a broad based ETF passive placement is not worth the risk.
We continue to advise that firms hold current or add selectively in dollar denominated debt that offers a more favorable risk to reward in the current environment. The Mortgage Backed I-Share (MBB) has an approximate yield of 3.41% with a duration of about 1.52. While spreads have come in, this is a favored space for many institutions that are simply unable to move out on the credit spectrum but who need carry. This for now is a reasonable space for some risk capital. Given the complexities of the mortgage backed market, we recommend a position with a seasoned manager who can navigate prepayment, extension and legislative risk as opposed to an ETF.
Our select manager in this space has been DoubleLine Total return run by Jeff Gundlach. The credit quality is much less than the ETF, however that carry will continue in spite of the issues with housing that we believe will persist. It has a yield of approximately 7% and a duration of about 2.5. That is a risk to reward we feel is prudent for a remainder of the year. It does have a fee for sales within 90day so if you want a more flexible tactical move, then an ETF may make more sense.
A fund with a similar duration is Osterweiss Strategic Income Fund. 66% corporate debt, 10% convertible debt and a little in the preferred space. Their flexibility holds appeal and they have been consistent over the years. A major downturn in the factors mentioned above this fund will suffer as well, however I would rather have my risk capital with this manager than with a passive exposure to HYG or JNK, two high yield ETFs with much more volatility.
While we only covered a small slice of the fixed income market, the hope is that your investment committee will assess your firm's credit and duration exposure in order to actively dial down unnecessary duration or poorly compensated credit risk.