The three 'risk pathways' for US fixed income

Payson Swaffield
— 1 minute read

Equity analysts will sometimes note that 'the bad news is out' when referring to fundamentally sound companies likely to turn the corner after a string of negative events, says Eaton Vance's Payson Swaffield.

Payson Swaffield

There is an analogy with the bond market for the remainder of 2016. We’ve crossed an important psychological threshold with the Fed taking the first step to raising rates, but sluggish economic growth makes it likely that subsequent hikes will be modest and gradual.

In our view the 2015 US debt market volatility created a number of interesting fixed-income opportunities across the risk/reward spectrum, which can be summarised presenting lower risk, value, and opportunistic. So where are the opportunities in 2016?

Lower-risk strategies

The lower-risk category is for investors more comfortable with limiting the risks historically associated with higher credit exposure. Examples are:

Municipal bonds: The credit picture for municipalities has seen gradual improvement in the years since the 2008 financial crisis, with the exception of a handful of well-publicised cases like Detroit and more recently, Puerto Rico.

Investors have taken note, and combined with modest movement in the U.S. Treasury yield curve last year, the municipal sector led the fixed-income pack for the second year in a row.

Our expectation for a continuing flattening of the yield curve in 2016 should create a favourable backdrop for municipalities. However, as we entered the new year, AAA-rated municipal-to-Treasury ratios have dropped to levels that indicate municipal bonds are no longer cheap; in 2016 active management will become particularly important.

Bond ladders: Though our base-case outlook does not anticipate significant rate increases at the long end of the yield curve, bond ladders may be a good choice for investors who are concerned about this scenario and commensurate capital losses.

A laddered municipal bond portfolio comprises a range of bond maturities from short to long.

If rates rise, the proceeds from maturing issues can be reinvested in higher-yielding, longer-term debt and contribute to enhancing total return over a future period.

In the same manner, investment-grade corporate debt may also be suitable for a laddered structure.

Absolute return: Absolute return strategies that (i) seek to generate returns with low correlations to both U.S. bond and equity markets and (ii) have relatively low tracking error to a short-term cash benchmark, would also offer investors a lower-risk option.

Value strategies

Floating-rate loans: This category assumes the investor is comfortable taking a little more risk, in return for what we believe are compelling values, and floating-rate loans are high on our list.

Loans are below-investment-grade debt with the unusual characteristic of being floating rate, secured by specific assets, and senior in a company’s capital structure.

TIPS (Treasury Inflation-Protected Securities): The return on TIPS is a function of the “real” rate tied to the Consumer Price Index (CPI), which grew by a scant three per cent annual rate as of the end of November. But even though inflation has been well-contained, one does not have to be an inflation “hawk” to note factors that could push it higher:

  • The strength of the dollar has been a major contributor to holding down inflation – it only has to stop rising for upward pressure on import prices to resume.
  • Unless gas prices keep sliding at the recent rapid rate, its impact on inflation is likely to fade.
  • Medical costs have been restrained by once-only events like the Affordable Care Act.
  • With unemployment down to five per cent, wages may finally be picking up.

As of 31 December, the annual inflation rate expected by the market for five years – known as the “break-even” rate – was 1.3 per cent.

If inflation expectations increase faster than nominal U.S. Treasury yields, then real rates go down, and push up TIPS prices.

Except for the financial crisis and its aftermath in 2009, TIPS break-even rates are at the lowest levels since the securities were introduced in 2003, and represent a contrarian value situation that we believe is worth considering.

Opportunistic strategies

High-yield bonds: We consider opportunistic strategies suitable for investors with a medium- to longer-term horizon, who are comfortable with taking more risk.

The case for high-yield bonds is very similar to that of floating-rate loans, in that prices are depressed, spreads are wide, and potential yields to maturity are relatively high – 8.7 per cent vs. 6.6 per cent for loans, before factoring in potential defaults.

As with loans, prices on high-yield bonds already discount default rates that are multiples of the current level.

High-yield bonds, however, have additional risk factors versus loans. There is greater exposure to the troubled energy and mining sectors, which amount to about 15 per cent of high-yield issuers, compared with about six per cent for loans.

High-yield bonds historically have had a lower recovery rate on defaulted issues. With high-yield defaults averaging about two per cent over the long term, and recovery rates of about 40 per cent, exposure to credit loss would be about 120 bps per year on average.

That leaves a considerable total return cushion in the event of a possible rising default rate in the coming year – something we expect, given that 15 per cent of the asset class is exposed to the energy sector.

Emerging-market local currency debt: In the past decade, emerging-market (EM) debt has firmly established itself as a mainstream investment.

For example, over the past six years there has been a five-fold increase in institutional holdings of EM debt to $600 billion.

But EM local currency debt has been hit hard by the strengthening dollar and the fall in oil and commodity prices, and for the past three years, it has been the worst-performing fixed‑income sector.

As with high yield, it is perilous to predict the bottom. But it is fair to predict that the dollar won’t keep strengthening indefinitely, and at some point commodity prices will stabilise.

Payson F. Swaffield is the chief income investment officer at Eaton Vance Management.


The three 'risk pathways' for US fixed income
Payson Swaffield
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