- Expect credit to experience more volatility and downward pressure.
- Investors should ensure their fixed income provides balance to their portfolio.
- Consider complements to high yield, and look to munis for more than just tax-free income.
Perception is catching up with reality
Are fixed income investors more concerned with interest rates or credit risk? For much of 2018, that answer was pretty obvious. Bond yields (which move inversely to prices) climbed as the Federal Reserve forged ahead with gradual interest rate hikes.
Indeed, concern that accelerating growth might prompt the Fed to raise rates more sharply helped spark an equity market correction in early 2018, and a steep rise of short-term bond yields in the interim.
Now, credit risk is coming into sharper focus for investors. Credit markets began to adjust in late 2018, when jitters about a global slowdown gripped markets and prompted the gap between credit and Treasury yields to widen. Fast forward to the present: For both investment-grade and high-yield bonds this gap — known as the credit spread — is at a nearly two-year high. In contrast, short-term Treasury yields have plateaued in recent months.
Looking ahead, credit spreads could widen more substantially in 2019 as investors demand additional yield as compensation for credit risk. “Concerns about interest rate risk are often front and center for investors during a rate hike cycle,” says Mike Gitlin head of fixed income at Capital Group. “But it’s important to note that while Treasury yields have already climbed, credit spreads remain relatively tight. Until valuations become more attractive, a degree of caution around credit seems appropriate.”
In a late-cycle economy, reality bites
In 2019, there’s good reason to anticipate more fragile investor confidence in credit, equities and certain other “riskier” asset classes. After all, stocks and corporate bonds had been on a tear for much of the past decade and most developed economies have entered the later part of their economic cycles.
Consider the U.S. economy. The unemployment rate recently hit 3.7% — the lowest in nearly three decades. Moreover, the number of job openings now exceed the number of unemployed Americans. Add to that the multi-decade peaks we’ve seen for consumer confidence and corporate debt as a percentage of GDP. In short, the U.S. is showing all the classic hallmarks of being late-cycle.
Changing expectations about the likely path of the Fed’s monetary policy in light of evolving economic data likely will add to late-cycle volatility. And not just because of rate hikes; the Fed’s changing balance sheet also matters. After nearly a decade of extremely accommodative policy, the Fed has moved from buying assets to stimulate the economy (quantitative easing) to selling those assets (quantitative tightening).
“Quantitative easing was an experiment. Quantitative tightening is also an experiment,” explains John Smet, fixed income portfolio manager for The Bond Fund of America®. “We think it's going to lead to more volatility, and riskier parts of the bond market doing poorly. We've just started to see some of that.”
Three key investment implications for investors
1. Be mindful of credit risk.
High yield has notched some of the highest returns in fixed income over recent years. Consequently, high-yield spreads are relatively tight, or in other words, valuations are high in historical terms.
If history’s a guide, high-yield investors should be prepared for a more challenging return environment over the next couple of years. When spreads have been close to recent levels, the subsequent returns for high yield have at best modestly outpaced Treasuries.
Historically, when high-yield spreads have been in their tightest quartile, Treasuries have returned four percentage points more, on average, over the following two years. Even in the second quartile, high-yield returns on average were near those of Treasuries.
Taking on significant credit risk for the potential of only incremental additional return does not seem like a good tradeoff. Also, unlike Treasuries and other high-quality bonds, high yield tends to be tightly correlated to equities. Instead, a more favorable choice may be high-quality bonds that can better withstand equity volatility. This is particularly true for a core bond allocation, which is meant to stabilize your broader portfolio.
Amid unsettled equity markets, it’s important for investors to be mindful that high yield can be a source of meaningful portfolio volatility. For those with a lower tolerance for volatility, a relatively limited high-yield allocation may be worth considering.
Also critically important is being on the lookout for unintentional credit risk in core fixed income allocations. Unfortunately, some core bond funds have prioritized boosting income over diversification and preservation. “Reaching for yield” often entails heavy investment in high yield.
We believe that core fixed income should seek to deliver balance to an overall portfolio by offering elements of all four of its key roles: diversification from equities, income, capital preservation and inflation protection.
2. Diversify portfolio income.
With prospects for high yield now on shakier ground, some investors have turned to floating-rate bank loans. That’s because rising interest rates tend to provide a tailwind to the income paid by this form of debt, also known as leveraged loans.
And yet, just as with high yield, valuations in floating-rate bank loans aren’t necessarily that attractive given the credit risk entailed. Investors often have to accept lower quality, weaker credit fundamentals and less creditor protection in the event of default than with high yield.
In comparison, high-income municipal bonds and emerging markets debt are attractive allocation options for investors who want to complement corporate high yield and diversify portfolio income. Both can provide similar levels of after-tax income as floating-rate loans or high-yield bonds. However, they also come with historically lower correlations to equities and higher credit quality.
Investors in high-income munis and emerging markets debt do have to accept a greater interest rate risk (as measured by duration). But if you don’t expect interest rates to go through the roof, these areas of the bond market could be worth exploring.
3. Look to munis for more than just tax-free income.
Sure, municipal bonds can offer attractive after-tax yields for investors in higher income tax brackets. But munis can be about a lot more than just income. Their historically low correlation to equities may make them useful in diversifying equities.
Although broader interest rate moves may prompt near-term volatility in munis, their credit fundamentals are solid across most sectors. Among diverse pockets of opportunity, consolidation of not-for-profit hospitals remains fertile ground for selective investors. In contrast, the outlook for tobacco-settlement bonds is gloomy. Fundamentals have deteriorated as smoking rates hit all-time lows and regulation tightens.
“If pressure on U.S. Treasury rates persists in 2019 and issuance of munis picks up to more typical levels, longer duration munis will likely soften,” says Chad Rach, portfolio manager for The Tax-Exempt Bond Fund of America® and American High-Income Municipal Bond Fund®. “That said, for longer term investors who do not anticipate sky-high interest rates, 2019 is likely to present some very attractive entry points for munis, particularly as all-in muni yields have reset to more favorable levels from a year ago.”
Methodology for calculation of tax-equivalent yield: Based on 2018 federal tax rates. Taxable equivalent rate assumptions are based on a federal marginal tax rate of 37%, the top 2018 rate. In addition, we have applied the 3.8% Medicare tax. Thus taxpayers in the highest tax bracket will face a combined 40.8% marginal tax rate on their investment income. The federal rates do not include an adjustment for the loss of personal exemptions and the phase-out of itemized deductions that are applicable to certain taxable income levels.
Investing outside the United States involves risks, such as currency fluctuations, periods of illiquidity and price volatility, as more fully described in the prospectus. These risks may be heightened in connection with investments in developing countries. The return of principal for bond funds and for funds with significant underlying bond holdings is not guaranteed. Higher yielding, higher risk bonds can fluctuate in price more than investment-grade bonds, so investors should maintain a long-term perspective.
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Bloomberg Barclays U.S. Aggregate Index represents the U.S. investment-grade fixed-rate bond market. Bloomberg Barclays Municipal Bond Index is a market-value-weighted index designed to represent the long-term investment-grade tax-exempt bond market. Barclays U.S. Corporate High Yield Index covers the universe of fixed-rate, non-investment-grade debt. Bloomberg Barclays High Yield Municipal Bond Index is a market-value-weighted index that includes below investment-grade tax-exempt bonds.
The Standard & Poor’s 500 Composite Index is a product of S&P Dow Jones Indices LLC and/or its affiliates and has been licensed for use by Capital Group. Copyright © 2018 S&P Dow Jones Indices LLC, a division of S&P Global, and/or its affiliates. All rights reserved. Redistribution or reproduction in whole or in part are prohibited without written permission of S&P Dow Jones Indices LLC.
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