Fixed-Income Insights

Fixed-Income Insights: A Way to Balance Yield versus Duration

Tue, 18 Jun 2013 02:45 EDT

Fixed-income investors currently face a delicate balancing act. They require sufficient yield to support a positive real return—but if they extend too high in credit quality or too far along the yield curve, investors likely will expose themselves to heightened interest-rate risk. Given these considerations, are there guidelines that investors might use to potentially tip the scales in their favor?

One such approach involves directly comparing an investment's yield to its duration. The takeaway is that a higher yield, relative to duration, may provide the necessary income to more than offset the price decline associated with rising rates. Such a conclusion can be especially relevant if the Federal Reserve slowly unwinds its aggressive easing policies of the past several years and we return to a more normal environment with less influence from the Fed.

A market environment with less Fed intervention could create a scenario wherein interest rates "normalize" over the course of five years, potentially resulting in a fed funds rate of 4%, which is the Fed's long-term projection, and a 10-year Treasury yield of about 5%, which is an assumption based on historical yield curve relationships and the relationship between the real 10-year Treasury yield and gross domestic product (GDP). And as this theoretical scenario unfolds, the difference between an investment's yield and duration could have a significant bearing on its potential price changes, income generation, and, therefore, cumulative total return.

For example, the assumed duration of the 10-year Treasury note, 8.4 years, multiplied by an estimated 300 basis-point change in interest rates over five years could result in a price loss of about 25%. When the rising income generated over that time frame is factored in, a five-year cumulative return on the 10-year note could still amount to a loss of more than 6%. A similar scenario could also prove disappointing to investments benchmarked to the Barclays U.S. Aggregate Bond Index, which (as of May 2013) consisted of about 75% government-related securities, as it could inch toward a cumulative gain of less than 4% over five years.

This meager estimated result means that investments benchmarked to the Barclays U.S. Aggregate Bond Index would have a very low performance hurdle of less than 1% per year in order to claim that the investments beat their benchmark over that period. While essentially treading water in a rising rate environment could disappoint many investors, those with TIPS [Treasury Inflation-Protected Securities] exposure could be in for an even ruder awakening, given the estimated loss of 12%.

Conversely, asset classes with yields that are higher than, or close to, their durations, may have a higher likelihood of posting positive real returns during the theoretical five-year normalization period. This dynamic is reflected in the estimated total return for floating-rate loans, high-yield bonds, and short-term corporate bonds with 'BBB' credit ratings.

While the guideline advocating that an investment's yield exceed its duration does not encapsulate the entire risk/reward spectrum for each position or allocation in a portfolio, the guideline could keep investors relatively insulated from the risk of normalizing interest rates. And the more investors hear from the Fed, the more it appears that they anticipate that the central bank is approaching a decision about curtailing its market participation and letting traditional market forces determine the appropriate level of long-term interest rates.

How Could the Yield versus Duration Dynamic Affect Total Returns?

Five-year returns of select investments as yields normalize*

Source: Bloomberg, Barclays Capital, Credit Suisse, and Lord Abbett.

For illustrative purposes only and does not reflect any Lord Abbett mutual find or any particular investment. Past performance is no guarantee of future results. The value of an investment in fixed-income securities will change as interest rates fluctuate and in response to market movements. As interest rates fall, the prices of debt securities tend to rise. As rates rise, prices tend to fall. High-yield securities, sometimes called junk bonds, carry increased risks of price volatility, illiquidity, and the possibility of default in the timely payment of interest and principal. Moreover, the specific collateral used to secure a loan may decline in value or become illiquid, which would adversely affect the loan's value. Like traditional Treasury bonds, Treasury Inflation-Protected Securities (TIPS) are issued by the U.S. Treasury and are guaranteed by the U.S. government. Although, TIPS are inflation-linked bonds that are fixed-income securities whose principal value is periodically adjusted according to the rate of inflation. In contrast, a Treasury bond's principal value is fixed. TIPS can be volatile and decline in value over the short term. This typically happens when interest rates rise.

Please note that forecasts and projections are based on current market conditions and are subject to change without notice. Market projections should not be considered a guarantee.

Fixed-Income Insights: Keep Calm and Carry On

Mon, 3 Jun 2013 02:45 EDT

A near-panic reaction to Federal Reserve chairman Ben Bernanke's comments—that the Fed could consider tapering its debt-buying program as soon as the next several meetings—ignored the Fed's premise that tapering would be dependent on self-sustaining economic growth. Investor overreaction pushed the yield on 10-year U.S. Treasuries temporarily to 2.23%, a rate likely to produce concern at the Fed if it were sustained, according to Bloomberg. Concern because a 10-year U.S. Treasury yield of 2.25-2.50% would push 30-year mortgage rates above 4%, likely stalling both housing and mortgage refinancing, key pillars of the current economic strength.

The Fed has repeatedly reminded investors that quantitative easing can be increased as well as decreased. A mortgage rate spike capable of dampening the economic improvement underway could be precisely the trigger for additional Fed purchases that would limit interest rates increases until self-sustaining growth becomes apparent. The yield on 10-year U.S. Treasuries may rise to 2.25% by year-end, but extrapolating May's yield increase to 2.50% or more in three to six months assumes an economy robust enough to tolerate 4-4.5% mortgage rates. We can only hope that such growth would occur so quickly.

Fixed-Income Insights: Back to the Future for Floating-Rate Loans?

Tue, 21 May 2013 02:45 EDT

As investors brace for the possibility of higher interest rates, they have sharpened their focus on floating-rate loans. And the heightened interest has been accompanied by the reemergence of some market attributes that may raise questions of how the market has evolved in terms of its ability to provide investors with an effective interest-rate hedge and positive real yields.

Investors' demand for yield can cut two ways as it relates to credit quality. The ability for companies to issue attractively priced debt has allowed them to extend their debt maturities and refinance existing liabilities. This increased flexibility has been accompanied by rising profits, resulting in an expected default rate of less than 2% in 2013 and in 2014, which would remain well below the long-term average of 3.8%, according to J.P. Morgan.¹

From an asset management perspective, the refinancing trend and the fact that loans can be called by the issuer at any time means that loans rarely trade at significant premiums to par, such as has occurred in many bond markets in recent years. While this aspect can support the yields on loans, managers are frequently facing refinancing or re-pricing scenarios, where they need to decide whether they still like the issuer at the new yield. If not, they may choose to sell part, or all, of a position.

The other side of companies' ability to issue inexpensive debt is that they may be inclined to assume more leverage, which could gradually weaken their credit quality. While corporate debt levels have been rising, they remain significantly lower than the levels at the height of the financial crisis. (See Chart 1.)

Chart 1. The Debt-to-EBITDA* Ratio Rises, but Remains Well Below the Pre-Crisis Froth

Source: J.P. Morgan.
* EBITDA stands for earnings before interest, taxes, depreciation, and amortization.
For illustrative purposes only and does not depict any Lord Abbett mutual fund or any particular investment.

However, the increase in leverage appears to have come from an increase in capital expenditures as they rose by 9% in the fourth quarter of 2012. Rising capital expenditures could be considered to be a constructive use of debt when, for example, compared to financing special dividends to private equity investors. And this latter use of proceeds still remains rare, with only 3.3% of the total loan volume in the first quarter of 2013 heading toward dividends, compared with 7.6% of the transactions in 2007.

The strong demand for floating-rate loans also has facilitated an increase in "covenant lite" offerings, which, among other factors, provide fewer protective clauses for investors in terms of overall debt levels or asset sales. Although covenant lite issuance recently increased, borrowers still appear focused on achieving the lowest cost of capital rather than egregiously loosening covenants.

While investors may be concerned that further increases in covenant lite loans could lead to an abundance of over-leveraged companies, U.S. banking regulators recently proposed guidelines for sound leveraged lending and underwriting practices. These principles could prevent a repeat of the widespread deterioration in underwriting standards that was observed throughout the capital markets prior to 2008.

Collateralized loan obligations (CLOs) have also recently reemerged in the floating-rate loan market, and these structured products can have multiple implications. Overall, the presence of CLOs can add to the demand for loans, and their presence in the market has been reflected by the $34 billion in CLO issuance as of mid-May 2013, which was more than four times the amount from a year ago.

On the other hand, CLOs may not be the most discriminate buyers because they have to invest substantial amounts often under time constraints. This broad demand provides the opportunity for active and astute portfolio managers to sell loans to CLOs at prices that may be above the manager's estimates for fair value.

Another difference in the current loan market compared with the pre-crisis environment is the prominent risk that investors may face within the debt capital markets, which for most investors is the threat of rising interest rates. And in this environment, investors should recognize the role that LIBOR² "floors" may play within the asset class. These minimum interest rates, which were recently around 100 basis points (bps), can support an attractive level of loan income in the low-yielding environment. Considering that LIBOR was about 30 bps as of mid-May 2013, these floors mean that investors may benefit from attractive yields today, but might not see higher coupons until rates move about 70 bps higher.

While investors may be disappointed at the delay in increased income, loans should maintain price stability, since it is estimated that loans could generally lose less than $1 in price due to an increase in short-term interest rates.³ Meanwhile, the floors do not change the minimal durations on loans, and they could also remain relatively stable with an increase in long-term interest rates that may cause particularly severe volatility in long-term bonds with high credit quality.

Although the floating-rate loan market has reacted to investors' rising demand for the assets, the recent changes involving leverage levels, structured products, and issuance trends should not compromise the prevailing attributes of the asset class. Thus, in a low-rate environment where interest-rate risk may be a looming threat, the potential for relative price stability and positive levels of real income should continue to provide value to investors.

Fixed-Income Insights: Here's Where Rates Could Be

Tue, 14 May 2013 14:45 EDT

Ever since the Federal Reserve inserted itself as the prevailing influence on long-term interest rates, questions have loomed about where rates might be with less intervention from the central bank. Should the Fed eventually curtail its market activity, economic and market forces would again become the driving factors behind interest-rate movements, suggesting a significantly higher 10-year Treasury yield based on historical measures and a recently released estimate from the U.S. Treasury Department itself.

How close is this transition? While periodic, weaker than expected economic reports may prolong the Fed's $85 billion in monthly asset purchases, the noise has grown louder about the mounting risks from stockpiling more than $3.2 trillion of assets on its balance sheet. So, the Fed may not require too much additional economic strengthening before it reduces its asset purchases, which might allow long-term interest rates to more accurately reflect economic and market conditions.

For investors with allocations benchmarked to the Barclays U.S. Aggregate Bond Index,¹ a more "normal" interest-rate environment could indicate zero total return for up to five years, considering that nearly 80% of the traditional fixed-income benchmark consisted of government and government-related securities, as of April 30, 2013.

One indication of where the 10-year Treasury yield could be with less influence from the Fed is gross domestic product (GDP), which, on average, has been remarkably closer to the long-term real yield on the 10-year Treasury note. Indeed, the average expansion of real GDP was 2.53% during the 20-year period that ended on February 1, 2013. This was only 4 basis points (bps) below the real yield on the 10-year Treasury note during the same time frame.²

Recently, there was a significant break in this coordination with the real yield on the 10-year Treasury dropping into negative territory, while real GDP expanded at a pace of 2.5% in the first quarter of 2013.³ While this historical relationship could be restored with either a decline in GDP or an increase in the real 10-year yield, an increase in rates may be the more likely scenario, given the influence of the Fed's prolonged purchases of Treasuries. Thus, if the typical state of the real 10-year yield is closer to 2.5% and the Fed is targeting an inflation rate of 2.0%, this could put the nominal yield closer to 4.5%.

One could essentially arrive at the same figure using the Fed's long-run projection for GDP, which was 2.4% in its Summary of Economic Projections from late March 2013 and its long-run inflation target of 2.0%.

A different method of estimating where long-term rates could be is by looking at historical relationships along the yield curve. And with the Fed anchoring the front of the curve near zero, the front of the Treasuries curve has remained in a similar position, with the three-month Treasury bill yielding 5 bps as of May 1, 2013, according to the Fed.

Before the Fed implemented its zero-bound policy, however, three-month Treasury bills had posted a long-term real return—comprised essentially of their real yields given their minimal price movement—of 1.2% from 1954 through 2007.⁴ (See Table 1.) If this is the historical relationship between the yields on Treasury bills and inflation, then looking forward with an expected inflation rate of 2.0% brings the potential nominal yield on the three-month Treasury bill to 3.2%. And with the long-term differential between the 10-year note and the three-month bill of 1.5%, this suggests a 10-year yield of 4.7%.

Table 1. Various Projections Show Similar, Theoretical 10-Year Treasury Yields with Less Fed Influence

Source: Federal Reserve, Bloomberg, Journal of Financial Planning, and the Department of the Treasury.
* 20 years ended February 1, 2013. The average expansion of real GDP over the same time period was 2.53%.
† From 1954 through 2007. Past performance is no guarantee of future results.
Treasuries are debt securities issued by the U.S. government and secured by its full faith and credit. Income from Treasury securities is exempt from state and local taxes. Longer-term debt securities are usually more sensitive to interest-rate changes; the longer the maturity of a security, the greater the effect a change in interest rates is likely to have on its price.

The concept of a 10-year Treasury yield in the area of 4.7% is also supported by the long-term yield-curve relationship between the fed funds rate and the 10-year note, which has been about 1.0%. This difference is, interestingly, lower than the one with the three-month bill, and that may be explained by investors' expectations for a reduced pace of inflation or further interest rate hikes once the Fed has already tightened monetary policy.

Therefore, with the Fed projecting that the long-term level for the fed funds rate is 4.0%, the yield differential of 1.0% to the 10-year note could suggest a yield of about 5.0% in a market with less central bank intervention.⁵

The similar outcomes of interest-rate projections in a more "normal" interest-rate environment are supported by a recently released report by the U.S. Treasury Department about potential changes in interest costs on the federal debt once the Fed starts exiting its policy accommodation. And the report explains that the main driver in a significant increase in future borrowing costs could be a higher 10-year Treasury rate of 4.3% over the next several years.⁶

Although interest rates have been on a declining trend for more than three decades, much of that has been without the Fed's broad influence on long-term interest rates, which may be set to decline over the next several years.

Therefore, in an environment where the 10-year Treasury yield could increase by up to three percentage points over the next five years, a consistent move among interest rate-sensitive markets could indicate a price decline of about 15% on the Barclays U.S. Aggregate Bond Index, given its duration of about 5.3 years as of mid-May 2013.⁷

As this yield normalization takes place, the index's yield of about 1.80%, as of mid-May, could drift higher and mostly offset the loss in price, which could translate to a five-year total return of about zero.⁸ For investors with allocations benchmarked to the traditional fixed-income benchmark, five years could represent a prolonged stretch of essentially standing still.

Fixed-Income Insights: Five Key Questions about High Yield, Part II

Tue, 23 Apr 2013 14:45 EDT

(Second of two parts. Read Part I here.)

This last installment about the key questions facing high-yield investors addresses the prospects for more leveraged buyout activity and how it might affect bondholders. This issue and the outlook for fiscal policy may be important factors for investors who are deciding on the role that high yield might play in their portfolios going forward.

Q. Does the recent activity regarding leveraged buyouts (LBOs), such as the purchase of Heinz and the potential private-equity acquisition of Dell, suggest a return to excess leverage throughout the market?
Leveraged buyouts can saddle the acquired companies with debt, which often prompts credit rating downgrades, and can increase the risk of default. And the news about the Heinz acquisition and the potential purchase of Dell—both large transactions in the area of $23–24 billion—have raised concerns that another wave of LBOs could contribute to weaker credit quality throughout the market.

This LBO activity, however, needs to be put into context of where the market has been and where it is currently. This progression is underscored by the potential increase in leverage to about 4.5 times earnings before interest, taxes, depreciation, and amortization (EBITDA) if Dell were to be acquired. Conversely, in the benchmark LBO of 2007, Energy Future Holdings Corp. (formerly TXU Corp.) was loaded up with $36 billion in debt, which took the company’s leverage to 10 times EBITDA.¹

The less egregious leverage amounts involved in the recent LBO activity reflect the liquidity that may be available to private equity firms and corporations. In the case of the Heinz LBO, Berkshire Hathaway contributed about half of the funding for the acquisition, with the remainder coming from loan and bond issuance.²

Overall, the leverage throughout the market continues to appear manageable for most companies. The debt that they carried in the fourth quarter of 2012 was 4.1 times EBITDA, which was still significantly lower than what existed during the height of the financial crisis, according to J.P. Morgan. (See Chart 1.)

Chart 1. The Debt-to-EBITDA Ratio Rises, but Remains Well Below the Pre-Crisis Froth

Source: J.P. Morgan.

Although leverage ratios have risen recently, it is important to recognize the factors that have contributed to the increase. From the perspective of debt investors, there may be constructive uses of debt, such as financing new machinery, and there can be less constructive uses of debt, such as financing a special dividend to private-equity investors. And in that context, the recent increase in leverage is relatively benign, considering that it has been primarily driven by an increase in capital expenditures.³

The 9% annualized increase in capital expenditures in the fourth quarter of 2012 occurred as companies may have found less success boosting their bottom lines through further cost cuts.⁴ Therefore, many companies have reached the point where they are seeking growth through investment in capital goods, such as new machinery. And if these capital investments support companies’ cash flow, this may, consequently, improve their ability to continue servicing their debt.

Q. How will U.S. fiscal policy affect the economy and the high-yield market?
The inability of the federal government to agree on key elements of a balanced budget, overhaul tax policy, and restrain growing entitlement programs remains a source of uncertainty among debt issuers and investors. While both participants may have accepted this uncertainty for now, an abrupt change in any aspect of fiscal policy, however unlikely, could cause some volatility.

Still, the U.S. economy faces some headwinds that are remnants of the “fiscal cliff” resolution earlier in the year. This included higher marginal tax rates on high-income taxpayers and a resumption of the 2% payroll tax. In addition, the sequestration of $85 billion in federal spending may also constrain growth this year as it hits certain sectors, such as defense, particularly hard.

Despite these restraints, personal consumption and business investment remain resilient. Economic growth has also been supported by the recovery in the housing market, owing in part to the assistance provided by the Federal Reserve’s quantitative-easing programs and the environment of historically low interest rates. The resultant low mortgage rates have promoted home ownership and facilitated refinancing for many households, which in turn has further supported personal consumption.

The combined effect of fiscal drag and ongoing monetary easing could result in relatively subdued economic growth of about 2% gross domestic product (GDP) in 2013. Absent additional fiscal austerity in 2014, GDP growth could improve next year. If the economic expansion accelerates and unemployment rate improves toward the Fed’s target of 6.5%, the central bank may curtail its quantitative-easing programs. Indeed, in the minutes from its most recent policy meeting, some Fed members suggested an adjustment to its asset purchases within the coming months or by the end of the year. If the interest-rate environment “normalizes” in the near future, this may prevent a sharp acceleration in economic activity, with growth possibly accelerating to 3.5% in 2014.

In a gradually expanding economy, fears about inflation should linger, even if they are not fully realized. This continues to indicate that high-yield securities might outperform higher-quality, interest rate-sensitive securities until inflation reaches intolerable levels or the economic cycle changes course.

Investor interest in high-yield securities has certainly been justified in recent years, and that demand has raised a number of questions for investors as they consider the role of the asset class within their portfolio. While these issues are not trivial and deserve further monitoring, the market may continue to benefit from the major factor that has underpinned its performance in recent years, which is the strengthening of credit quality. And as long as interest rates remain near their historically low levels, corporate balance sheets should remain healthy and, most likely, validate high-yield as a long-term holding.