Fixed Income: Opportunities & Threats

The prevailing winds for fixed income investments are shifting. Ever decreasing interest rates over the last three decades were a tailwind for rising bond prices, providing comfort to bond investors who saw the values of their bonds escalate in response to the declining yields.

From where we stand today, however, the outlook for a global secular rise in interest rates is becoming more probable. Along with rising interest rates, investors will need to factor in other obstacles, such as expected increases in tax rates, inflation rates and credit concerns. This article will address the role of fixed income in a diversified portfolio, expand on the potential risks ahead and suggest strategies to effectively navigate the forthcoming challenges.

The Role of Fixed Income

Investors have traditionally allocated a portion of their portfolio to fixed income assets to provide both capital preservation and lower volatility. These assets are most frequently used to generate income, provide adequate liquidity to meet spending requirements and add diversification. With a low correlation to other asset classes (i.e., equities), fixed income has been a critical component in the overall asset allocation process necessary to accumulate and sustain investment assets. Given the inevitable changes in the fixed income landscape, investors must actively re-evaluate how their fixed income investments are structured in order to meet their desired objectives.

Challenges in an Evolving Market

Over the full course of this transitional period in the fixed income market, we are likely to experience the following obstacles:

  • Rising interest rates
  • Credit concerns with sovereign, federal, municipal and corporate borrowers
  • Rising tax rates
  • Increasing inflationary pressures
Nominal interest rates literally have no way to go but up. As the U.S. economy continues its efforts to stabilize, the flight to safety that drove treasury yields down to nearly zero should fade. Capital flows to riskier assets should increase, making room for treasury rates to gradually move upward.

The large deficits facing governments around the world should also play a role in rising interest rates, as higher returns must be offered to compensate for the additional risks investors are being asked to accept. On a global sovereign scale, Portugal’s credit has been downgraded, Greece is in the midst of being rescued and other AAA rated governments are at risk of being downgraded. In the U.S., the budget deficit is set to hit $2.43 trillion in 2010 (following a fiscal deficit of $1.4 trillion for 2009). While a downgrade in U.S. credit is not likely, the nation’s growing debt is reaching unsustainable levels. At the municipal level, states continue to struggle with their budgets, a consequence of a protracted decline in property values and decreased tax revenues. At the corporate level, investors have regained confidence in corporate bonds. In fact, corporate debt has significantly outperformed government bonds on a relative basis since the market hit bottom in March 2009. In what may be a less rare event in the future, a U.S. corporate issue (2/10, 2yr. Berkshire Hathaway note) was trading at a yield level less than a U.S. Treasury of the same maturity. This environment suggests that the markets know no patriotism when it comes to an out-of-order fiscal house. As we look forward, credit quality of the issuer and default risk must be key factors in the investment decisions.

The risks of rising tax rates and inflation have a similar effect on fixed income investors. In the battle between what you make and what you really keep, these two influences can derail an unattended fixed income portfolio. Given the environment we are facing, after-tax, inflation-adjusted income and liquidity needs should be primary concerns for any fixed income investor, especially those who rely on their fixed income investments to meet their living needs or other commitments.

Navigating an Evolving Market

As rates begin to rise, investors holding long duration bonds may be left watching the market values of their holdings slip as newer issues become available carrying higher stated interest rates. Maintaining at least a portion of your fixed income portfolio with a shorter duration can help directly confront this risk. To tackle certain credit risk, corporate step-up bonds have had record issuance in recent months, since they provide coupon payment increases if the issuer is downgraded. While these market mechanisms and others can certainly dampen risks, we believe navigating the upcoming environment is based on the interwoven concepts of diversification, fundamental analysis and a global worldview.

Diversification in your fixed income assets, as well as in your equity investments, will spread the systematic and specific risks in any environment over several securities and strategies. For taxable fixed income investors, a core component of municipal bonds combined with tactical allocations to corporate, agency, Treasury Inflation Protected Securities (TIPs) and overseas markets will dampen the effect of any declines that could come to any specific issuance, sector or market. Municipal bonds are a useful tool to generate tax-exempt income and their tax equivalent return will be even more attractive as tax rates rise. Additionally, to directly combat the effects of inflation, investors should also consider an allocation to TIPs, which provide protection against inflation since the principal of the TIPs will increase as inflation rises.

As the paradigm changes from one of perceived quality and blind faith reliance on ratings agencies, experienced in-depth analysis and manager acumen are invaluable in comparing various fixed income issues and finding true quality. In a market where quality can no longer be defined in historical terms, it is important to understand the underlying drivers of value. Value investing involves determining value based on the fundamental assessment of a borrowing entity’s ability to repay the underlying collateral pledged; covenants or conditions within the lending agreement; and the character, business qualifications and operating record of management.

Global investing will help sidestep inflation risk by gaining exposure to non-U.S. dollar denominated bonds issued by sovereign, multilateral or corporate entities. Exposure to commodity currencies and resource rich emerging markets with accelerating growth rates can assist portfolios by acting as a natural hedge against inflation expectations domestically.

A properly structured bond portfolio should provide for both principal protection and be flexible enough to handle all of the risks we described. The solutions discussed are interrelated and, by themselves, will not adequately serve as protection in a changing fixed income market. Exposure to the global marketplace should provide additional opportunities to look for value while maintaining the structure and integrity of fixed income portfolios exposed to these fluid market conditions. With such a challenging environment, using experienced managers and/or funds with the resources and track record to effectively analyze the fundamentals of each security to implement your fixed income strategy is imperative.