While we maintain a bias toward 10-year rates ending the year around or above 3%, we continue to think short-dated rates will be anchored for the foreseeable future. This will leave the yield curve as steep or steeper than it is today (see figure).
We currently recommend those seeking principal protection look to bonds maturing in 2017, rather than being pinned down to low-yielding, shorter-dated securities. This approach should benefit from the “roll” in the yield curve which refers to a bond gaining value as it becomes shorter and its yields decline (yield down = price up). 2017 represents the steepest part of the yield curve.
Example of the “Roll”:
|Bond #1||US Treasury 2.375% 7/31/17
Yield to Maturity = 0.93%
|Bond #2||US Treasury 3.250% 7/31/16
Yield to Maturity = 0.45%
|Difference = 0.48%|
Hypothetically if short-term interest rates were to remain the same for one year, Bond #1 would enjoy a 0.48% “roll down” the curve and would be priced similar to where Bond #2 is today (intuitively a three-year bond becomes a two-year bond). As a result, the principal and income would produce a total return of 1.92% (compared to one-year treasury rates which are 0.075% or one-year CD’s which are roughly 0.30%. (In addition, Bond #1 has a current yield of 2.27% which may also appeal to certain clients.)
We currently favor high BBB names versus A- and A rated names for moderate risk investors and would overweight the three- to seven-year part of the yield curve to take advantage of the roll effect mentioned above.
While we note that rate hike expectations may have been dampened somewhat, corporate fundamentals still appear to be quite strong. As a result, credit spreads have continued to tighten toward levels that may be unsustainable. Once ten-year rates reach 3%, we expect this trend to turn as those seeking yield will be more comfortable reducing their credit risk and may be satisfied with the yields of government and agency bonds.
We maintain a shorter duration bias and remain cautious of a correction in the credit market.
As a result of the Market’s constant banter about higher rates, retail investors have flooded into the short-end (zero to seven years) of the municipal market causing supply/demand imbalance that has created an overvalued market. As a result, we are advising some clients to contemplate taxable alternatives to municipals in order to achieve a higher after tax income while preserving principal.
For clients with a longer time horizon (and can stomach principal volatility), we feel the longer end of the curve (15+ years to maturity) offers the best value as state level general obligation bonds offer yields that are cheaper than treasury bonds (pre-tax) and offer twice that to Treasury bonds after tax.
Example: A Massachusetts General Obligation bond maturing in 2033 yields 3.79% (compared to a US Treasury in 2036 which yields 3.18%). The after tax equivalent yield is a 6.68% for those in the top tax bracket.
Complacency, supported by solid year-to-date performance, will likely set the preferred market up for greater volatility should demand pull back due to higher Treasury yields. The magnitude of the volatility will depend on the manner in which rates rise or credit spreads change. The sell-off of last May and June, caused by the language of the Federal Reserve, should serve as a case study of how preferreds are vulnerable to supply/demand imbalances.
We would use the current rally in prices in lower-coupon securities as an opportunity to reduce duration in these long perpetual securities. We feel investors should reposition these holdings in favor of preferred’s with more defensive features and specifically should reduce exposure in those that pay a fixed coupon below 6.5%. We continue to recommend high-coupon securities and fixed-to-float preferreds with high back-end floats (coupons that adjust monthly or quarterly).
We continue to favor a basket approach as to not overweight one theme, sector or name.
We recently reduced our exposure to the bank loan space in favor of an unconstrained higher yielding approach that allows our managers to invest in sectors that offer the most current opportunity. Current themes include U.S. Commercial Real Estate as well as European residential real estate. We view European RMBS as an optimal instrument to play the fundamental European recovery theme. Among the $400 billion publicly distributed outstanding European RMBS, we believe Spanish RMBS offers the best scalable and higher-yielding opportunities, with a high margin of safety and good liquidity. We believe RMBS in UK, Portugal, Greek, Italian and Ireland also offer selective opportunities with similar value proposition.
We invest in this sector via open-ended mutual funds.
Disclosure: Data is for informational purposes only and should not be considered as marketing for any Pennsylvania Trust mandate or service and should not be considered a solicitation or an offer to provide any Pennsylvania Trust service in any jurisdiction where it would be unlawful to do so. The views expressed represent the opinions of Pennsylvania Trust and are not intended as a forecast or guarantee of future results. The sectors, industries, countries and regions discussed herein should not be perceived as investment recommendations and may no longer be held in an account’s portfolio. It should not be assumed that investments in any sector, industry, country or region discussed were or will prove profitable. Sector/industry weights and country and regional allocations of any particular client may vary based on investment restrictions applicable to the account. There may be additional risks associated with international investments. International securities may be subject to market/currency fluctuations, investment risks, and other risks involving foreign economic, political, monetary, taxation, auditing and other legal factors. These risks may be magnified in emerging markets. Pennsylvania Trust believes that transactions in any option, future, commodity, or other derivative product are not suitable for all persons, and that accordingly, clients should be aware of the risks involved in trading such instruments. There may be significant risks which should be considered prior to investing. All securities trading, whether in stocks, options or other investment vehicles, is speculative in nature and involves substantial risk of loss. Indices are unmanaged and not available for direct investment. Past performance is no guarantee of future results. All data as of 6/3/2014.