by Kevin Kelly
Portfolio Manager
2019 was an exceptionally strong year for fixed income, as well as for the equity markets. One consequence is that 2020 will be more challenging and require a somewhat different approach. We are unlikely to see the strong returns we captured in 2019, so we must position for low rates and tight spreads. Nonetheless, we are still finding opportunities to help fixed income investors achieve their two chief goals: preservation of capital and enough income to stay well ahead of inflation.
2018 was a relatively weak year across the entire fixed income market, which set the stage for 2019. In fact, it was the first year since 2008 that experienced negative total returns across the investment grade, high yield, and preferred market. This set up 2019 well for the possibility to be a very good year if the economy, the Fed, and / or sentiment could stabilize or improve even marginally. But 2019 benefitted from a major reversal in the interest rate outlook by the Fed. Instead of hiking interest rates, the Fed became increasingly more dovish throughout the year and actually cut rates three times in 2019. The Fed had not cut interest rates since the financial crisis, so this was a noteworthy reversal, especially given market expectations of continued hikes. The Fed actions complemented a weaker global economic outlook, so several central banks refocused on maintaining accommodative policies. Additionally, investor confidence improved as the trade war abated and the U.S. and China moved towards a phase 1 agreement, which tightened credit spreads and led to a substantial stock market rally.
The bond market rally leaves fixed-income investors in 2020 struggling to find yield, since interest rates are low and credit spreads are very tight. Currently, the average 10-year investment-grade bond yield less than 2.8%, while high yield bond yields average approximately 5.1%. Investment grade spreads are very tight and near post-financial-crisis lows, while high yield credit spreads tightened significantly in 2019 and also remain close to post-crisis lows. Regarding preferred stock, while providing an average is not meaningful, the preferred market is in a similar relatively low yield predicament. Many preferreds have rallied so significantly that they are now trading at a negative yield to a potential redemption or a yield that is below the corresponding Treasury (many investors probably don’t realize this).
Herein lies the beauty of an unconstrained fixed income investing approach. We can buy a little of this and a little of that. We can cherry pick by buying the best investment grade securities, the best high yield securities, and the best preferreds to manage the risk/reward tradeoff in the current environment. With low rates and tight credit spreads, risk management should be the main focus for a fixed income portfolio. There are currently very few higher-yielding, solid credits that are also simple stories from a credit and business perspective. This is where industry knowledge and deep credit analysis are crucial. Regarding positioning, we believe we can maximize our returns in the near term by selecting higher quality, medium to long-dated securities, and pairing those picks with carefully chosen shorter-dated securities. The former can provide compensation for taking on more credit risk even as the short maturities help protect us on the downside should credit spreads widen. The lower the rating of a security, the more the credit spread tends to widen or tighten during market fluctuations. As a consequence, a longer-dated, lower-rated security is typically more vulnerable during times when credit spreads are very tight. This is why analyzing portfolio construction is essential as market opportunities change.
We are confident that if we remain patient, more compelling risk/reward opportunities will present themselves. History has proven time and time again that sell-offs typically happen quicker than rallies and we must remain disciplined and patient. In the meantime, we will take advantage of the select opportunities we find in high yield bonds and across the rest of fixed income as our unconstrained approach provides us with this unique flexibility. But we are also just waiting to pounce as compelling opportunities present themselves.
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