Our ongoing Q&A series features Carillon Tower affiliate managers sharing their diverse investment philosophies and thoughts on the market.
Interest rate activity and the return of volatility have focused attention on income markets. Eagle Asset Management Managing Director James Camp shared his thoughts on strategy in this space.
We believe it’s unlikely the Fed will increase rates this year. The Fed has stood down as a result of slowing inflation growth and declining economic data. The yield curve, as measured by the spread in yields between the 10 Year US Treasury note and the 3 month US Treasury bill, has already inverted. The bond market is telling the Fed to slow down and it appears for now that they are listening. Absent a surprise to the upside, economic growth looks to have peaked in the third quarter of 2018, an outcome we had projected since our commentaries in the summer of 2018. Without a material uptick in inflation and economic growth, we find it hard to believe that long-term interest rates will move materially higher
The amount of bonds around the world with negative yields has skyrocketed over $10 trillion, up from just under $6 trillion at the beginning of October. Generally, lenders receive a rate of return to lend money. In this case, lenders are paying money to lend money. The only logical reason to own a negative-yielding asset is if one feels strongly that the direction of rates will continue to go deeper into negative territory. We feel a 2.4 percent 10 Year U.S. Treasury yield is compelling, given the strong fundamentals of the U.S. economy, especially in light of the economic and political challenges other countries are facing in Europe and Asia. We believe the relative attractiveness of Treasury yields will keep a lid on yields here in the United States. Given this backdrop, as well as where we’re at in the cycle, high-quality U.S. bonds look particularly attractive to us.
High-yield and leveraged loans are areas we believe fixed income investors should avoid. Spreads have tightened materially in recent months, so investors are not getting the proper compensation for the incremental risks they are taking. We refer to these securities as “equity-lite,” since their risk and return profile has more closely mirrored that of stocks throughout history. The covenants in these bonds protecting bondholders are by and large very weak. When there is a crack in credit, the potential for loss may be higher than in previous downturns. Unfortunately, many investors are not aware of the additional risks they may take for such a meager increase in yield.
Some of the problems we’re seeing in high yield also extend to the lowest quality names in the investment grade category, namely the BBB space. There has been a proliferation of names in the BBB space, with more than half the corporate bonds currently in the Bloomberg Barclays Corporate Bond Index teetering one step above junk. The near-zero risk-free rate environment over the past decade has incentivized many companies to lever up. On the plus side, there are select companies with attractive yields that get lumped into the same bucket as some of these poorly managed companies based off of a credit rating that may have been given out by a credit rating agency years ago. Credit research and active management can help identify those companies that are utilizing a disciplined capital allocation policy with specific guidelines for reducing or maintaining leverage.
Interest rates are still very low compared to long-term historical averages. Meanwhile, companies have been increasing their dividends at a rapid pace due to the cash windfalls from fiscal stimulus and an expanding economy. This has created unique opportunities where investment-grade companies have stocks that out-yield their bonds. For investors who are comfortable with a company that fits this criteria, we think it makes sense to buy that company’s equity since it provides the potential for higher dividend income as well as possible upside potential due to stock price appreciation. These situations are not the norm, but they have become more common given the current low-interest-rate environment. We believe a blend of bonds, preferred securities and carefully selected common stocks can provide similar income and total returns to high-yield bonds, but with much lower risk.
We have been seeing some warning signs in the corporate space for some time. If you look at various leverage metrics across the corporate sector as a whole, leverage is just as high if not higher now than at other peaks in previous cycles. While past is not always prologue, this is something we are keeping an eye on. Active management can help identify companies that are able to navigate well through a variety of market environments.
Given that 2018 was the worst corporate bond year for total returns since 2008, we are seeing outflows from some of the passive vehicles that both creates pressure on the net asset value for those products and gives us the opportunity to buy inexpensive paper from those funds. If you look at high-quality taxable bonds in 2018, we were net sellers of credit, in favor of Treasury bonds, which outperformed over the course of the year. I think active management in fixed income has always had a leg up relative to equity counterparts. However, as we see a lessening of the environment in which free money tended to raise all risk boats together, we are confident that security selection in both the tax-free municipal space and the corporate space is going to be of paramount importance for performance going forward.
Eagle Asset Management provides a broad array of fundamental equity and fixed-income strategies designed to meet the long-term goals of institutional and individual investors. Eagle’s multiple independent investment teams have the autonomy to pursue investment decisions guided by their individual philosophies and strategies.
To learn more about Eagle Asset Management click here or contact us at 800.521.1195.
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Carillon Tower Advisers provides support services, including marketing and sales, to affiliated advisers. Carillon Tower Advisers’ affiliates (Eagle Asset Management, ClariVest Asset Management, Cougar Global Investments, Scout Investments and Reams Asset Management, a division of Scout Investments) manage a broad range of investment vehicles, including separately managed accounts, mutual funds, closed-end funds, UCITS and other types of products.
Risks associated with Fixed Income investing: many investors consider bonds to be “risk free” investment vehicles. Historically, bonds have indeed provided less volatility and less
risk of loss of capital than has equity investing. However, there are many factors that may affect the risk and return profile of a fixed-income portfolio. The two most prominent
factors are interest-rate movements and the creditworthiness of the bond issuer. Bonds issued by the U.S. government have significantly less risk of default than those issued
by corporations and municipalities (see footnotes 3 and 4 below for a discussion of the risk associated with high-yield bonds and convertible securities). However, the overall
return on government bonds tends to be less than these other types of fixed-income securities. Investors should pay careful attention to the types of fixed-income securities that
comprise their portfolio, and remember that, as with all investments, there is the risk of the loss of capital.
This material may include forward-looking statements. These statements are not historical facts, but instead represent only beliefs regarding future events, many of which, by their nature, are inherently uncertain. You should not place undue reliance on forward-looking statements as it is possible that actual results and financial conditions may differ, possibly materially, from the anticipated results and financial conditions indicated in these forward-looking statements. There are uncertainties, unknown risks, and other factors that may cause actual results, levels of activity, performance or achievements to be materially different from any future results, levels of activity, performance or achievements expressed or implied by these statements.
The statements above are based on the views of the advisor and are subject to change.
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The information presented is not tax, investment or legal advice. Prospective investors should consult with their advisers.
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