Q&A with Chief Investment Officer Mark Heppenstall
After nearly three decades of steadily declining interest rates, the current rising rate environment has provided an attractive opportunity for fixed income investors to consider an unconstrained strategy, which offers greater flexibility than traditional active fixed income strategies.
Mark Heppenstall, chief investment officer, shares his view on the benefits of taking a diversified, unconstrained approach to your fixed income allocation.
Q: What kind of approach to fixed income might you consider given where interest rates are headed?
In the world of interest rates, there are a few things happening right now that I think favor an unconstrained strategy as opposed to a pure index-based or a core plus active strategy. One being the recent trend toward higher interest rates. The Federal Reserve has increased interest rates seven times now, with the front end of the yield curve reacting quite dramatically, while interest rates at the long end of the yield curve remain low.
The ability for the long end to stay low is mostly driven by foreign central banks, the European Central Bank (ECB) and the Bank of Japan (BOJ), that are at negative or zero interest rates. In the event that the ECB and BOJ unwind their easy money policies and bring their investors back home, I think that the long end is still susceptible. This event would have the potential to create selling pressure within the long end of our yield curve. That means I would favor short to intermediate-duration securities that are less exposed to an increase in interest rates at the long end of the yield curve.
Q: What about an unconstrained approach makes sense today and in the near future?
For the past 20 years, current inflation measures have consistently been below the Fed’s 2 percent target. Given the low unemployment rate and the economy running at near-full capacity, the Fed has been somewhat perplexed that we haven’t seen inflation pressures start to build. Easy money policies by the Fed and other central banks have been put in place to push inflation higher. There’s a risk that the monetary policy may overshoot the process, especially when taking into account some of the recent fiscal stimuli that have been implemented as part of tax reform and the new budget agreement that significantly increases spending.
Fiscal stimulus of this sort so late in the cycle runs the risk that inflation may surprise investors and the Fed. This argues for a more short to intermediate-duration approach to investing in fixed income today, as opposed to the core plus active fixed income benchmarks that are running at about a six-year duration.
There are structural characteristics of the index that I think will dampen returns for investors. Specifically, the U.S. agency mortgage-backed securities in the index, because their duration will actually extend even further as interest rates rise. This is exactly the opposite of what you want in terms of having shorter duration in a rising interest rate environment. An unconstrained approach, considering how flat the yield curve is today, may add value for investors simply through the flexibility to be opportunistic with duration and credit.
Q: How does an unconstrained approach allow investors to counteract inflation, and prepare for a shift to rising rates?
Passive and core plus fixed income benchmarks do not include Treasury inflation-protected securities (TIPS) as part of their holdings. By having the greater flexibility of an unconstrained approach, an investor can utilize TIPS outright, or hedge out the nominal interest rate risk using treasury futures or interest rate swaps, and turn the TIPS into a pure inflation-expectation play.
Throughout this long-standing disinflationary environment, investor expectations for inflation are still low compared to some historical readings of the U.S. economy and experiences of other global economies. Therefore, I think having the flexibility to add TIPS as part of the unconstrained strategy adds value to fixed income portfolios, as they are one of the few instruments that are a pure play on higher inflation.
Q: What are some of the more overlooked areas for fixed income investors seeking quality, stable portfolio income?
Floating rate securities are an attractive alternative. The broad core plus indices do not have floating rate assets as part of their holdings. As such, active managers are often underexposed to floating rate assets. We’ve seen a fairly significant increase in the three month LIBOR for a number of both technical and fundamental reasons. With the three month LIBOR now trading above 2.3 percent, it is a very attractive benchmark to reset your floating rate securities.
Regarding other areas, I have a general bias toward identifying short duration, below investment-grade securities, or high yield securities. This bias is a relatively safe way to capture some of the high yield beta, but with much less credit risk than the overall high yield market. To that extent, I strive to identify corporate credits with improving fundamentals that are likely to cross over from BB into BBB. Often, very short duration securities offer a positive risk/reward profile. That’s not something your typical active manager will normally hold, so it tends to be a somewhat underappreciated part of the market that offers great risk-adjusted returns.
Q: Which areas stand to hold up best during a rising rate environment?
In terms of assessing a fund’s ability to hold up in a rising interest rate environment, I think investors can focus on portfolio duration, which is purely the measure of interest rate risk in a fixed income portfolio. In today’s environment, you’re getting paid less and less to take incremental risk both in the Treasury yield curve and the corporate curves.
So, again, I think the best opportunities may reside at the front end of the yield curve on a risk-adjusted basis. I would say TIPS offer the benefit of diversification and the ability to cushion a portfolio against an increase in inflation. An increase in inflation tends to be negative for the bond market as it erodes the value of owning a fixed coupon in any type of an interest rate environment. Whether it’s from expected or unexpected inflation, having TIPS and floating rate assets will help cushion a portfolio against any rise in rates that might be coming.
Key Takeaway
Due to Fed tightening and recent flattening of the Treasury yield curve, long-term fixed income assets are not producing the same degree of reward as in years past. As a result, common core plus and active strategies are likely to offer lower risk-adjusted returns looking ahead.
As the long-term bond bull market gradually rolls over, an unconstrained approach is a strategy that allows for more flexibility to generate competitive returns than traditional active fixed income investments.
The views and opinions expressed in this material are as of the date published, and are subject to change based on market and other conditions. This material contains certain views that may be deemed forward-looking statements. Any forecasts contained in this material are based on various estimates and assumptions, and there can be no assurance that such estimates or assumptions will prove accurate. This material is intended for information purposes only. Actual results may differ significantly.
Past performance is not indicative of future results. Investors should be aware of the additional risks associated with investments in non-diversification, non-investment grade debt securities, undervalued or overlooked companies and investments in specific industries. Additional risks may include those associated with investing in foreign securities, emerging markets, IPOs, REITs, derivatives and companies with relatively small market capitalizations.
In addition, investors should be aware of the additional risks associated with investments in non-investment grade (High-Yield) debt securities and structured securities, which are subject to greater fluctuations in value and risk of loss of income and principal as a result of interest rate risk and economic risk. Additional risks may include those associated with investing in foreign securities, emerging markets, currencies and derivatives.
Risks associated with derivatives include the risks of the underlying instruments, substantially greater gains and losses than the derivatives’ costs due to the leverage.
Short sales are speculative transactions with potentially unlimited losses, and the use of leverage can magnify the effect of losses. Diversification neither assures a profit nor eliminates the risk of loss.
This information herein does not constitute investment advice and the products described may not be available to, or suitable for, all investors. You should consider, if appropriate, obtaining independent professional advice before making an investment decision.
Definitions:
London Interbank Offered Rate (LIBOR): The rate of interest at which banks borrow funds, in marketable size, from other banks in the London interbank market. LIBOR, the most widely used benchmark or reference rate for short term interest rates, is an international rate. The London Interbank Offered Rate is fixed on a daily basis by the British Bankers’ Association (BBA). The rate is an average derived from 16 quotations provided by banks determined by the British Bankers’ Association, the four highest and lowest are then eliminated and an average of the remaining eight is calculated to arrive at the fix, Eurodollar Libor is calculated on an ACT/360 day count basis and settlement is for 2 days hence.
