Volatility Worries? Consider This Diversified Approach to Income

A strategic combination of ultra-short and short-term fixed-income securities, along with bank loans, may be an attractive option for income and total return amid market turmoil.

In Brief

• Amid the current volatility, fixed-income investors may be assessing their options for income. Last week, we discussed the historically attractive performance of bank loans, while noting their potential for volatility given their exposure to credit risk.
• In addition to bank loans, we think there are other appealing short-term investment grade choices. As short-term rates have moved higher, investment-grade ultra-short and short-term bond sectors have shown a consistent yield advantage over U.S. Treasury bills.
• We believe that these asset classes could work well in tandem, as a three-part blend of ultra-short and short-term securities with bank loans offers the potential for high income and steady returns amid a volatile market.

Volatility has ratcheted higher across asset classes in recent weeks, affecting interest rates, equities, and credit markets. Rising interest rates and fears of slowing earnings growth fueled a sharp decline in equities that began in early October. That risk-off environment more recently led to widening credit spreads, helping to push prices of high-yield bonds and bank loans lower. The “flight to quality” subsequently produced to a decline in U.S. Treasury yields. What are investors to do?

Recent media reports have noted large inflows into short-term exchange traded funds (ETFs) that invest in short-term U.S. Treasury bills and notes, suggesting investors are seeking to avoid risk. Such periods of volatility have often created attractive long-term buying opportunities. But for those investors looking to limit the risks associated with equities, credit, and interest-rate movements, are Treasury bills the best option?  We would suggest there may be other choices worth examining.

Last week, Market View focused on floating rate bank loans, a below-investment grade asset class that historically has offered high income with reduced interest-rate exposure. For those looking to limit credit risk, there are other options to consider. Chart 1 illustrates the yield available on several low-duration, investment-grade asset classes. All of them recently offered a yield spread over ultra-short term U.S. Treasury bills (T-bills), and their yields have consistently adjusted higher as short-term rates have risen, historically generating positive returns and increasing income streams.
 

Chart 1. Short-Term Rates Have Been Adjusting Higher Since the 2016 Low in U.S. Treasury Yields
Index yields, July 1, 2016–November 16, 2018

Source: Bloomberg. 3 Month T-bill= ICE BofAML U.S. 3-Month Treasury Bill Index. CP (Commercial Paper)=U.S. Federal Reserve (Fed) 90-Day A2/P2 Nonfinancial Commercial Paper Rate (Fed publishes average yields but not performance). IG FRNs (Investment-Grade Floating-Rate Notes)=Bloomberg Barclays U.S. Floating Rate Note Index. Short IG Corporates= ICE BofAML 1-3 Year U.S. Corporate Index. Short ABS (Asset-Backed Securities)= ICE BofAML U.S. 0-3 Year ABS Index. Short CMBS (Commercial Mortgage-Backed Securities)= Bloomberg Barclays U.S. Non-Agency Investment Grade 1-3.5 Year CMBS Index.
The information shown is for illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment.  Statements concerning financial market trends are based on current market conditions, which will fluctuate. There is no guarantee that markets will perform in a similar manner under similar conditions in the future.  Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment. Past performance is not a reliable indicator or a guarantee of future results.

Let’s take a closer look at these asset classes, grouped by their characteristic duration, and how they may work as part of a strategic combination with bank loans:

1. Ultra-Short Bond Strategies – Such strategies are generally defined as portfolios having a duration of less than one year. One component of this strategy may be investment-grade floating rate notes (FRNs). These offer a source of floating-rate income without duration exposure, based on a spread over the three-month LIBOR (London Interbank Offered Rate); unlike bank loans, FRNs are an investment-grade asset class.

As illustrated in Chart 1, FRNs have offered a consistent yield advantage over T-bills, and have regular coupon adjustments, which have allowed the asset class to maintain this yield advantage as short-term rates have risen. The result has been consistently higher returns, as demonstrated in Chart 2, which compares monthly returns of the representative Bloomberg Barclays Floating Rate Note Index (FRN Index) to the ICE BofAML U.S. Treasury Bill Index (T-bill Index).
 

Chart 2. Floating Rate Notes: A Consistent Historical Record of Positive Returns
Monthly returns by index, July 2016–October 2018

Source: Bloomberg. FRN= Bloomberg Barclays U.S. Floating Rate Note Index. U.S. T-bills=ICE BofAML U.S. Treasury Bill Index.
The information shown is for illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment.  Statements concerning financial market trends are based on current market conditions, which will fluctuate. There is no guarantee that markets will perform in a similar manner under similar conditions in the future.  Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment. Past performance is not a reliable indicator or a guarantee of future results.

Since the low point in yields in July 2016, the FRN Index has generated positive returns in all 28 months, and higher returns than the T-bill Index in all but two months. By comparison, the broad bond-market benchmark Bloomberg Barclays U.S. Aggregate Bond Index (Aggregate Index) has had negative returns in 14 of those 28 months.

2. Short-Term Bond Strategies – Short-term bond strategies typically invest in a one-to-three year maturity range, for an effective duration of approximately two years (about one-third the interest-rate sensitivity of a typical core bond strategy benchmarked to the Aggregate Index). Chart 1 includes index yields on key short duration investment-grade credit sectors, including short-term corporate bonds, commercial mortgage-backed securities (CMBS), and asset-backed securities (ABS). All of these recently offered higher yields than Treasuries of comparable maturity, and have also seen yields adjust higher in recent years.

While there is some credit risk in owning short-term corporate bonds, for example, over Treasuries, the risk of default historically has been quite small. During periods of volatility, spreads may widen and prices may decline temporarily. But barring any real credit issues, which we believe can be avoided with rigorous credit research, such securities ultimately mature at their par value. This is especially true with very short maturities. While it is more difficult to forecast what may happen to a company’s credit profile over the next 10 years, there is more clarity over shorter horizons (say, owning a two-year corporate bond, or 30-day commercial paper). This “pull to par” limits price volatility on short maturity securities.

As a result, short-term credit sectors have generated higher absolute returns and higher risk-adjusted returns than the Aggregate Index over the past one, three, and five years.

3. A Blended Approach – Last week, we highlighted the strong performance of bank loans, which have outperformed both the Aggregate Index and the high-yield benchmark (ICE BofAML U.S. High Yield Index) over the past year, and have held up relatively well during the recent bout of volatility. But bank loans are a below-investment grade asset class that is subject to credit risk, particularly if U.S. economic growth decelerates at a faster pace than economists’ projections. While many have forecast that default rates in bank loans will continue to remain near historically low levels over the next year, the asset class may be subject to some price volatility should investors continue to flee risk.

That said, we believe bank loans can continue to play an important part in fixed-income portfolios. One approach to generating high income with limited duration exposure, while mitigating credit risk, could be a blended portfolio combining bank loans with short-term bond and ultra-short bond strategies. While ultra-short and short-term strategies can invest across multiple asset classes, for simplicity we have constructed an equal-weighted portfolio of an investment-grade FRN index (representing ultra-short bonds), a short-term corporate bond index (short-term bonds), and the Credit Suisse Leveraged Loan Index (representing bank loans). Based on the index data in Table 1, such a blend could generate a current yield of approximately 4%, with an overall duration of less than one year.
 

Table 1. Where Might Investors Find Income with Limited Duration?
Index yields versus duration, as of November 19, 2018

Source: Bloomberg.
*Floating Rate Note and Bank Loan indexes depict average coupon.  All other yields are index yield to worst. Aggregate Index=Bloomberg Barclays U.S. Aggregate Bond Index.
U.S. T-bills= ICE BofAML U.S. Treasury Bill Index. Commercial Paper=U.S. Federal Reserve 90-Day A2/P2 Nonfinancial Commercial Paper Rate (Fed publishes average yields but not performance). Floating Rate Notes=Bloomberg Barclays U.S. Floating Rate Note Index. Short-Term ABS (Asset-Backed Securities)= ICE BofAML U.S. 0-3 Year ABS Index. Short-Term CMBS (Commercial Mortgage-Backed Securities)= Bloomberg Barclays U.S. Non-Agency Investment Grade 1-3.5 Year CMBS Index. Short-Term Corporates= ICE BofAML 1-3 Year U.S. Corporate Index. Bank Loans=Credit Suisse Leveraged Loan Index.
The information shown is for illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment.  Statements concerning financial market trends are based on current market conditions, which will fluctuate. There is no guarantee that markets will perform in a similar manner under similar conditions in the future.  Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment. Past performance is not a reliable indicator or a guarantee of future results.

Chart 3 shows how such a blended portfolio would have performed since the recent low point in rates in July 2016.  While bank loans have generated the highest returns, other investment-grade asset classes such as short-term corporate bonds and floating rate notes have posted positive returns, compared to the negative returns of the Aggregate Index, and have outperformed short-term T-bills by a meaningful amount. A blended portfolio of these three segments can provide a diversified approach to generating income while limiting interest rate and credit exposure.
 

Chart 3.  Shorter-Duration Securities Have Offered Positive Returns in a Difficult Market
Cumulative index returns, June 30, 2016-November 20, 2018

Source: Bloomberg. Aggregate=Bloomberg Barclays U.S. Aggregate Bond Index. ST Corps= ICE BofAML 1-3 Year U.S. Corporate Index. Bank Loans= Credit Suisse Leveraged Loan Index. IG FRNs= Bloomberg Barclays Floating Rate Note Index. Blend=Equal combination of Bloomberg Barclays U.S. Floating Rate Note Index (33 1/3%), Credit Suisse Leveraged Loan Index (33 1/3%), and the ICE BofAML 1-3 Year U.S. Corporate Index (33 1/3%) . T-bills= ICE BofAML U.S. Treasury Bill Index.
The information shown is for illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment.  Statements concerning financial market trends are based on current market conditions, which will fluctuate. There is no guarantee that markets will perform in a similar manner under similar conditions in the future.  Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment. Past performance is not a reliable indicator or a guarantee of future results.

Summing Up
Investors are always faced with uncertainty. After a long period of relatively low volatility, investors now seem more uncertain than they have in some time. Although the past few weeks have certainly not felt good, such periods of volatility are quite normal, and may create attractive long-term opportunities. For those looking to avoid the volatility in equities, a diversified portfolio of low-duration strategies can provide attractive income with limited interest-rate risk, along with the potential to benefit from further rate increases by the U.S. Federal Reserve (Fed). But such a strategy need not depend on further rate hikes.  Even if the Fed were to pause, the income based on current rates could still lead to attractive risk-adjusted returns.