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.
Two years ago, the risk-free rate on the 10-year Treasury was about 1.4 percent. In late 2018, that was about 3.05 percent. So by definition, the opportunities for more conservative income generation are much more generous than they were just two years ago. In addition, on the equity side of the market, since 2016 there was a dramatic outperformance of non-dividend paying stocks. But that has changed significantly over the recent past, and several major companies that are not dividend payers, especially in the technology sector, have suffered significant market declines. At the same time, income-producing equities have really shined in both absolute performance and their ability to grow income through dividends. So income investing, which is generally considered a more conservative approach relative to growth investing, has an opportunity set to me that is more generous prospectively than it has been retrospectively. Another factor is that corporate bond yield spreads – the yield from corporate bonds relative to Treasuries -- have gotten more generous. We recently saw a 4.25 yield on a five-year corporate bond, levels we haven’t seen since 2008. Future income streams are better now than they have been in years, and bond yields now solidly outpace broad equity market yields.1
High-yield and ending with costs are rising. The new sentences should read: Although high-yield bond spreads have widened in recent weeks, they are still tight on a historical basis. Covenants protecting bondholders are weak, leverage is higher than in previous cycles, and borrowing costs are higher. Historically, high-yield bonds have had a high correlation with stocks. When there is a crack in credit, high-yield bonds won’t protect investors. Unfortunately, many investors are not aware of the additional risks they may take for such a meager increase in yield.
We believe future increases in long-term rates will be totally data-dependent. Remember, interest rates on the long end of the curve are primarily influenced by inflation expectations, not the Federal Reserve’s actions. We’ve yet to see consistent economic data, despite some improvement and thus the adjustment upwards in rates. It is our belief that wage growth – a key indicator of inflation – will need to show strength for prolonged periods before we see another significant adjustment upward in long-term rates. The long end staying range-bound places a limit on how quickly the Fed can raise rates for fear of inverting the yield curve. On top of this, global yields remain suppressed, and the Fed is the lone central bank removing stimulus. Without an uptick in global yields or policy shift, the 10-year is unlikely to sustain a yield above about 3.05 percent. The move from 1.4 percent to 3 percent over two years for the 10-year Treasury is the lion’s share of the “pain” that will be felt in this resettling of interest rates.
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 higher 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.
Active management can focus more on determining whether the credit quality is truly investment grade. What we are seeing in corporate America is a number of investment grade companies that might be teetering. Credit is much more complicated than simply looking at a rating from Moody’s or S&P. Also, given that this has been the worst corporate bond year for total return 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. Secondly, if you look at high-quality taxable bonds in 2018, we have been a net seller of credit, in favor of Treasury bonds, which have outperformed. This gives us investible assets for what we view as a more generous corporate market going into 2019. I think active management in fixed income has always had a leg up relative to equity counterparts. But as we see a lessening of the environment in which free money tended to rise 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.
Carillon Tower Advisers is a global asset-management firm supporting autonomous boutiques spanning investment disciplines and asset classes, each with a focus on risk-adjusted returns and alpha generation. We believe this lineup of institutional-class portfolio managers can help investors meet their long-term business and financial goals. Ultimately, this structure allows investment teams to focus on what they do best: managing portfolios.
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.
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