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Financial Industry Insights from Advisors Asset Management
On June 20, 2016
AAM Viewpoints - Understanding Risks in Fixed Income
As we approach the end of the 2nd Quarter, the majority of U.S. taxable fixed income markets are ahead of U.S. equity markets on a year-to-date basis. As of market close on 06/10/2016, the S&P 500 was up 3.58% year-to-date after dividends. Contrast this, over the same time frame, with the U.S. Treasury market up 4.56%1, U.S. Investment Grade corporates up 6.64%2, U.S. High Yield up 9.13%3, and taxable municipals at 8.45%4. While fixed income markets in the United States are outperforming equity markets for the year, they are doing so for very different reasons. More interest rate sensitive markets such as U.S. Treasuries, taxable municipals and high grade corporates have benefited from lower interest rates over the course of 2016. The 10-Year Treasury ended 2015 in the 2.25% range and, as of the close on 06/10/2016, we were roughly 60 bps (basis points) lower at 1.65%. Lower investment grade corporates and high yield have benefitted from lower rates but, more importantly, have strengthened due to a general narrowing of credit spreads which reflects the more credit sensitive nature of these investments. Bond markets in 2016 provide a good illustration of the two major drivers of fixed income returns, namely interest rates and credit spreads. There are numerous risks that could impact bond total return performance but the two primary risks, most important to the majority of fixed income investors, are interest rate risk and credit risk. Fixed income holdings are sensitive to these two factors in varying degrees and understanding both is key to constructing diversified fixed income portfolios that are suitable for a given client risk tolerance.
Interest rate risk is defined as the risk associated with a change in the prevailing interest rate environment5. The price levels, for most fixed income securities, are inversely related to interest rates. As interest rates fall bond prices rise and as interest rates rise bond prices fall. Interest rate risk is a consideration of fluctuations in bond pricing due to interest rate movements. As interest rate risk is increased the reward or compensation for accepting the risk increases as well, normally in the form of increased yield. The additional compensation for accepting more interest rate risk is referred to as the “term premium” and is best illustrated by an upward sloping Treasury yield curve which offers additional yield as maturity or interest rate risk is increased.
Source: U.S. Department of the Treasury
Maturity does provide some insight into interest rate risk but our preferred measure is duration. Duration goes one step further than maturity and gives us insight into the sensitivity of a bond’s price to a change in interest rates. Duration approximates the percentage change in price for a 100 bps (basis points) movement in interest rates. For instance, the current 10-Year Treasury (T 1.625% 05/15/26) has a duration of 9.24 years and with a 100 bps increase in interest rates the security should lose approximately 9.24% in value. Longer duration provides more return but also leads to more price volatility, while shorter duration reduces interest rate risk but provides lower returns and presents the possibility of having to reinvest in a low rate environment. With duration in hand we can position fixed income portfolios with interest rate sensitivities that match client risk tolerances and return expectations.
Credit risk is defined as the risk that an issuer will default on its obligation to the investor to pay principle and interest on a timely basis6. Default impacts both a bond’s price and cash flows as the issuer will normally cease making interest and/or principle payments but credit risk can also impact a bond’s price even outside of a default as credit spreads widen to reflect the markets perceived increase in risk. Credit spreads are the primary gauge of credit risk. Credit spreads represent the difference in yield between a riskless (no credit risk) U.S. Treasury bond and another debt security of similar structure and maturity.
Source: Federal Reserve Bank of St. Louis
Credit spreads represent the compensation to the investor for accepting risk, in this case credit risk. As perceived credit risk falls credit spreads narrow, yields fall and bond prices increase. The opposite holds true as perceived credit risk increases: credit spreads widen, yields increase and bond prices fall. The U.S. High Yield Energy sector, over the course of the last year and a half, provides a stark example of credit spread widening and narrowing as a driver of bond returns. The collapse in energy prices, weakening commodity demand and concerns over global growth all weighed on the U.S. High Yield Energy sector in 2015 leading to the worst annual performance in the history of the index. The sector was down -23.575% in 2015 as sector credit spreads widened almost 650 bps from 756 bps to end 2014 to 1405 bps to end 20157. Energy sector credit spreads continued to widen through February 2016 hitting an all-time high, surpassing even the 2008 spread, on February 11 at 1984 bps. As financial conditions in the sector improved spreads began to narrow and, as of the close on 06/10/2016, had narrowed 1177 bps to 807 bps driving a sector return of 50.80% from 02/11/2016 to 06/10/2016. While credit spread movements are normally nowhere near this extreme the example does illustrate an important point in regards to credit risk. Credit risk and credit spreads are a function of financial conditions within a sector or economy.
Source: St. Louis Fed
As you step down in credit quality bonds become more sensitive to the same factors that typically drive equity returns and less sensitive to the prevailing interest rate environment. As prospects for growth and expansion improve, financial conditions ease and credit spreads narrow. Credit spreads widen on prospects of contraction or slowing growth and tighter financial conditions. With an understanding of credit spreads it becomes easier to properly position portfolios with exposure to credit risk within the confines of the investors risk tolerance while providing the means to enhance fixed income returns.
We believe diversified fixed income portfolios should have exposure to both interest rate and credit risk as each play a different role, providing stability while enhancing returns. An allocation to more rate sensitive higher grade fixed income such as U.S. Treasuries, U.S. Agencies and high grade taxable municipals and corporates can potentially help to reduce volatility. Rates tend to fall during periods of financial stress as investors shun riskier assets such as equities and high yield for safer assets such as U.S. Treasuries. This is referred to as the “flight-to-quality” trade and the downward pressure on rates tends to benefit most rate-sensitive fixed income to varying degrees.
Adding exposure to higher credit quality bonds can potentially help provide stability and potentially offset volatility in riskier portions of a client portfolio. Credit risk, on the other hand, has the potential to help enhance returns and help offset weakness in higher grade bonds when and where rates rise. The Federal Reserve begins to tighten when and where they are concerned about inflation and the economy overheating. This would normally occur amidst generally healthy credit conditions with improving corporate balance sheets, strong equity markets and lower-than-average corporate default rates. Because credit spreads are sensitive to the health of an economy and spreads tend to narrow as financial conditions improve, credit risk carries the potential to provide some cushion in portfolios during periods of higher rates. Lower rated bonds are still susceptible to interest rate movements but potential credit spread tightening could help to improve overall total return performance. The primary consideration in adding interest rate and credit risk exposure to a portfolio should always be client risk tolerance, primarily in regards to price volatility. With additional yield comes the potential for additional volatility regardless of whether the increase in return comes from an increase in duration or taking on additional credit risk in the form of wider credit spreads. Clients should understand and have a comfort level when taking on each risk as they may or may not be appropriate for a specific client situation.
CRN: 2016-0606-5391R
This commentary is for informational purposes only. All investments are subject to risk and past performance is no guarantee of future results. Please see the Disclosures webpage for additional risk information. For additional commentary or financial resources, please visit www.aamlive.com.
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