AAM Viewpoints – It’s All About the Income
“In this world, nothing can be said to be certain except death and taxes.”
- Benjamin Franklin, Excerpt from a letter to Jean-Baptiste Leroy
While one can be certain of very little in the “world” of fixed income investing, history shows us time and time again that total returns rely on “time in the market, not timing the market.” The closest thing to a universal truth for fixed income investors is that long-term returns are almost always dominated by coupon and income. Without calling the direction of rates or the horizon of the current expansion, investors should take comfort that staying invested is likely the best course of action. Unlike equities, where income carries the potential to reset higher via dividend increases, cash flows from fixed income are as the name implies: fixed. Maximizing these fixed cash flows, relying on the compounded income growth on reinvestment and minimizing cash sitting on the sidelines are the dominant factors in long-term fixed income total returns. If there is anything to take away from recent events in the fixed income markets it is the concept of time in the market.
2018 was not a good year for fixed income markets. The abrupt reversal through Q1 (1st quarter) 2019 has left one to wonder where we go from here. As late as October 30,2018, 19 of the 20 largest Bloomberg Barclays Global Indices, as well as the broad U.S. Municipal Aggregate, were all in the red for the year. The only exception was U.S. High Yield, up less than 1%. Flight to quality assets caught a strong tailwind with a “December to Remember” as interest rates fell sharply on growth concerns and the S&P 500 was off more than 9% over the month. In high-grade markets, U.S. Municipals finished 2018 up 1.28% and U.S. Treasuries and U.S. government-related debt all eked out gains of less than 1%. On the credit side of the ledger, U.S. High Yield, the best performing U.S. asset class through 10 months of the year finished down -2.08% after sharp credit spread widening to finish out 2018. Fast forward a quarter and as of the close on March 29, 2019 the 20 largest Bloomberg Barclays Global Indices plus U.S. Municipals are all solidly in positive territory year-to-date. More credit sensitive areas of the market are leading the way with U.S. High Yield up over 7% and U.S. Investment Grade Corporates up over 5%. Higher-grade, more interest-rate-sensitive asset classes such as U.S. Municipals (+2.90%) and U.S. Treasuries (+2.11%) are also posting solid gains a quarter into the year.
There seem to be two major drivers behind the recent strength across fixed income markets.
- We are seeing increasing global growth expectations, especially in China, confirmed with improvements in recent global economic data. This has led to a renewed appetite for risk driving up equity markets around the world and U.S. High Yield and lower U.S. Investment Grade right along with it.
- Concerns over the path of U.S. monetary policy have eased significantly. Generally, one would expect higher rates with expectations for economic improvement along with a Federal Reserve biased toward a tightening stance. In fact, we are seeing lower interest rates with the Fed on pause and arguably having shifted to a more accommodative stance. Improvement in the global economic backdrop has supported the recent rally in risk assets and provides a tailwind to lower quality fixed income such as high yield and the BBB area of the investment grade market. The shift in monetary policy along with broadly lower rates have benefited the balance of fixed income markets but are especially important as it relates to the rally in higher grade debt. The sharp reversal from Q4 2018 through Q1 2019 in risk-based assets coupled with a rally in interest rates again reminds that time in the market trumps timing the market.
Even in the most price-sensitive areas of the fixed income markets, coupon return dominates price return. Consider the rolling 10-year annualized return as of the end of Q1 2019 of 11.25% in U.S. High Yield (03/31/2009 – 03/29/2019). The 10-year timeframe in question is one of the more volatile from a credit spread standpoint with sharp widening during the 2008 period followed by sharp contraction and includes one the largest moves down in interest rates we have seen in recent memory. With significant moves in both rates and credit spreads, coupon return in the asset class still constituted 9.54% or 85% of the 11.25% total return. The speed of the recent rebound, especially in U.S. High Yield, further reinforces the notion that one is probably better off staying invested through periods of price volatility. The last drawdown for U.S. High Yield (10/03/2018 – 01/03/2019) began early in Q4 (4th quarter) 2018 with credit spreads touching cycle lows of 303 bps (basis points) on October 3, 2018. Volatility ensued, and credit spreads topped on January 3, 2019 at 537 bps. By February 5, 2019 the drawdown had ended, and we began setting new index highs in the asset class and have not stopped since. Where staying invested through bouts of volatility is important for all fixed income investors, it is paramount for higher grade investors seeking capital preservation and income, in our opinion. As you move higher in credit quality coupon return constitutes an even larger portion of total returns even after accounting for interest rate movements. The rolling 10-year annualized return as of the end of Q1 2019 in the U.S. Municipal market was 4.72%. This timeframe (03/31/2009 – 03/29/2019) includes a broad move down in interest rates with the 10-year U.S. Treasury moving from 4% to 2.60%. Coupon return for the timeframe accounted for 4.62% of the 4.72% total return or 98% of total return.
It remains to be seen how long both an improving economic backdrop and broadly lower interest rates can co-exist. Broad economic improvement likely brings more inflationary pressures and higher rates which, in turn, would be headwind for higher grade debt but provide a tailwind for lower grade holdings. A return to consternation over economic growth and concerns over a slowdown likely support lower rates and would portend more credit spread volatility in lower grade debt but support prices in higher grade holdings.
Regardless of your view, in our opinion, investors should rest easy with the knowledge that staying invested through periods of interest rate and credit spread volatility is likely the best course of action in maximizing total return potential. We would argue that whatever your stance on the direction of the economy and interest rates moving forward, a plan that includes maximizing cash flows and minimizing cash on the sidelines most likely wins the day. Small tactical shifts in interest rate and credit exposures can certainly be warranted but will almost certainly not trump time in the market.