Davidson Investment Advisors
Relative to the volatility of equity markets, most fixed income investors prefer their portfolios to be comparatively…boring. They are intended largely to preserve capital and produce income in the form of interest payments, as well as provide a means of asset class diversification. As such, it has been a surprise to many over the last couple of months to see the value of their bonds fall in their portfolio.
Bond prices move inversely to bond yields. When bond yields move up, the market value of bond prices automatically adjust, falling in tandem so that the current purchasers of bonds in the open market realize the current market yield of the bond.
We note that while the price decrease in bonds reflected on client statements as a result of rising interest rates may grab some attention, it does not suggest the bond or note holder is at risk of not being repaid the full face value of the bond or note at maturity. Rather, it suggests that if the investor desires to sell the bond before maturity at a price reflecting a higher yield than when the instrument was purchased, they would incur a loss of principal. During the holding period, the investor would observe unrealized losses of market value of the bond or note on their statements if the coupon yield at the time of purchase is lower than the current market yield for the note or bond on the valuation date of the settlement. Importantly, the unrealized loss on the bond will decrease as the bond approaches maturity over time, so long as interest rates remain stable and no changes to the credit profile of the bond take place.
As the market anticipates an accelerating economy in a post-COVID world, the fixed income market may recalibrate to account for this future growth potential in the form of further rising interest rates. Notably, if sustained, this would represent the first period of rising interest rates since the late 1970s and early 1980s. As investors have enjoyed a forty-year bull market in bonds (falling rates result in increased prices for bonds, all else being equal), managing portfolios in this new environment presents a challenge that many investors have not experienced.
This portfolio perspectives will explain how we at Davidson Investment Advisors seek to position and manage bond portfolios in this environment.
The Importance of Risk Awareness
For fixed income investors, relative judgements are made when purchasing a new bond or note. Does the rate of return provided by the bond today sufficiently compensate the bondholder for risk they are taking? Will there be a better opportunity for the investor to capture greater returns at a comparable level of risk at some point in the future? Answering these questions requires reaching a number of subjective conclusions, all informed by the following considerations:
- The likelihood of the bond issuer to repay bondholders. The lower the probability of repayment, the higher the interest rate an investor will demand for the bond relative to a risk-free rate of return. The additional compensation one receives for taking on additional risk is often referred to as “spread.”
- The expected rate of inflation. By definition, inflation makes money in the future worth less than the same amount of money today. To compensate for the risk of losing future value through inflation, investors must be comfortable that the yield they receive on bonds today will help sustain their real purchasing power.
- Expectations of future interest rates. If an investor expects higher interest rates in the future, they benefit by having liquid assets to invest at such times. This helps determine the term of their loan (the time it takes to get their principal back).
- Opportunity costs. If investing in two debt instruments of comparable duration and credit quality, there is an opportunity cost to buying one of them that provides a lower rate of return. This applies not only to two comparably-rated credits, but on a tax-equivalent basis between municipal and taxable bonds as well.
As professional money managers, we seek to add value for our clients by applying a deep level of analysis to these questions. We actively research the credits in which we invest, gaining comfort in both the promise of repayment and the quality of the issuers in our portfolios. We study the broader economy deeply to discern the likely direction of future interest rate and inflation trends. We also apply this analysis to the structure of our portfolios, actively determining the most optimal positioning from a duration and maturity structure perspective. In other words, risk awareness drives our process of putting clients’ money to work in bonds.
How We’re Investing Today
Under the premise of gradually rising interest rates over the next few years, our team is investing in fixed income primarily to protect principal today for opportunity tomorrow. With relatively low yields across fixed income markets presently, we are also resisting the temptation to stretch for yield,-either from a credit quality perspective (buying lower-rated bonds) or from a duration perspective (buying higher-yielding longer-dated maturities).
Looking forward, we do have a number of tools at our disposal to help mitigate the impacts of rising interest rates.
First, security selection remains a key factor in our investment process. Not only does being selective in credits give us comfort in repayment by issuers, but it also allows us to find relative value opportunities between credits to increase the yield profile of portfolios without materially increasing risk. For example, within the same credit rating, bonds may trade at various yields due to the nature of the issuing entity, the liquidity of the bond issue itself, or some other factor. This presents opportunities for us to pick up bonds at either higher yields or better credit profiles than other similarly-rated bonds available. It also affords us comfort that in a rising rate environment, the underlying credit profiles of the bonds we select for clients will remain resilient.
Second, we can actively structure accounts to remain resilient and positioned for a rise in interest rates, especially relative to broad bond indices or passive bond ladders. Exercising our discretion, we may invest the bulk of client accounts with shorter durations than comparable indices. Doing so means two things: first, portfolios are less prone to price changes due to rises in interest rates; and second, a steady flow of bonds maturing in the portfolio that frees up cash to reinvest at presumably higher rates in the near future.
We can also change the structure of maturities in the account to reflect the best return opportunity relative to the yield curve by laddering bond maturities, by creating a barbell with maturities at the short end of the yield curve and at the longer end but less in the middle, or by bulleting account structures to take advantage of specific points on the yield curve that reflect compelling relative value.
Finally, as an active bond manager, we can also be selective in the amount and types of securities we purchase in order to better combat rising rates and add value. For example, as a boutique investment manager we have the ability to act nimbly relative to larger bond funds who need more volume to satisfy customer orders. Such large buyers often end up competing for large bond allocations and driving prices higher as a result. We also look for securities with certain kinds of features that can add value in this environment. For instance, we are currently looking for bonds with wide call windows in hopes that in a rising rate environment, issuers will be less inclined to call their outstanding bonds and reissue debt. This is analogous to a homeowner choosing not to refinance if mortgage rates have risen above the breakeven cost to do so. Such bonds are priced according to their anticipated call date (known as Yield to Call or Yield to Worst), meaning that additional coupon payments received by bondholders after the presumed call date are essentially enhanced return relative to expectations when purchased.
Rising rates may have some short-term impacts on portfolios, but we view a higher-rate environment than the one we’ve been in for the past number of years as healthy and good for fixed income investors. Though adjustments to portfolios may be necessary as rates settle at a new level, we are encouraged that we can do what we seek for clients – to preserve capital and to generate income – at more attractive rates in a higher prevailing rate environment. Of course, the possibility also exists that rates could fall from today’s levels, and though our team views this possibility as less likely we do maintain a similar set of tools to take advantage of this scenario as well. At Davidson Investment Advisors, we believe actively managing fixed income portfolios can provide opportunities to generate attractive risk-adjusted returns across market environments.
Davidson Investment Advisors is a SEC registered investment advisor. The opinions expressed herein are those of Davidson Investment Advisors and are subject to change. The information contained in this presentation has been taken from trade and statistical services and other sources, which we believe to be reliable. We do not guarantee that this information is accurate or complete and it should not be relied upon as such. This presentation is for informational and illustrative purposes only, and is not intended to meet the objectives or requirements of any specific individual or account. Past performance is not an indicator of future results. An investor should assess his/her own investment needs based on his/her own financial circumstances and investment objectives.