With the outlook for global economic growth firming, the Federal Reserve appears poised to continue raising its target for short-term interest rates. Brandon Kanz, senior principal and head of credit for Galliard Capital Management, says that may not deliver the benefits many fixed-income investors desire.
Despite the Fed’s more accommodative monetary policy, Kanz warns that the U.S. economy isn’t likely to rev up, on a sustained basis, to the levels it enjoyed before the 2008 financial crisis. Meanwhile, he notes, interest rates around the world remain near historic lows. He predicts this will leave fixed-income investors fighting the same battle they’ve been fighting for nearly a decade now: searching for yield. And to his way of thinking, they shouldn’t be too aggressive in their hunt—especially if they’re managing stable value portfolios.
Speaking at the SVIA’s 2017 Fall Forum, Kanz said three traditional ways to boost the yield on a fixed-income portfolio—by extending its duration, taking on more credit risk or increasing the allocation to agency mortgage-backed securities—are all problematic right now.
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Duration: The Treasury yield curve is the flattest it’s been since 2007, Kanz noted, which means the reward investors get for moving out on the curve isn’t commensurate with the risk they’re taking. Meanwhile, yields on the 10-year Treasury note, while above their post-crisis lows, are still lower than they’ve been at any other time since 1950. Accordingly, he sees more room for rates to move higher than lower.
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Credit risk: While corporate earnings remain healthy, and corporations themselves aren’t extraordinarily leveraged after accounting for the cash on their balance sheets, positive fundamental factors like those could be overwhelmed by less favorable technical factors, Kanz warned. He noted that spreads between corporate bonds and Treasuries are near the tightest levels seen since the 2008 financial crisis, meaning that once again investors aren’t getting as much reward as they would want for taking on more risk in the credit sector. He advised fixed-income managers to maintain a defensive position by focusing on higher-quality issuers, overweighting the front end of the yield curve and maintaining a high level of diversification within their portfolios. He also suggested they be on the lookout for, and wary of, companies that might over-leverage their balance sheets to fund shareholder rewards or pay for mergers or acquisitions.
- Agency MBS: The Federal Reserve owns about $1.7 trillion in mortgage-backed securities purchased as part of its quantitative easing program since the financial crisis. That’s equal to about 29 percent of the MBS market. The Fed is now preparing to start unwinding those purchases, and even though it plans to proceed at a measured pace the net supply of MBS will likely increase substantially starting next year, Kanz said. Such an increase will likely have an adverse impact on pricing. He also noted that as securities with negative convexity, MBS have both prepay and extension risk, and as such would underperform securities with positive convexity in a rapidly changing interest-rate environment, should one arise. He recommended that stable value managers adopt a neutral position in the asset class while watching for opportunities to increase exposure if the market cheapens. He also recommended they focus on shorter-tenor mortgages, or look for unique opportunities to pay up for better convexity relative to generic pass-through securities.
While the current environment is generally challenging for fixed-income investors, Kanz said stable value is in a good position relative to competitors. Average stable value yields of 2 percent are approximately 100 basis points higher than yields on money market funds, for example. He said stable value also compares favorably with longer-term fixed-income products where the flat yield curve is limiting the benefits of extending duration. By way of example, he noted that the duration of the Barclays Aggregate bond index is about 3.5 years longer than the duration of the typical stable value fund, while offering a yield advantage of approximately 50 basis points.
“The final option for stable value managers is to simply stay defensive,” Kanz concluded. “The temptation to invest in more aggressive structures and riskier products is generally a sign we are approaching the end of a cycle. We feel the best course of action is to stay true to the purpose of stable value, focusing on principal preservation by maintaining a high-quality, diversified portfolio and making sure we protect our clients from whatever risks may come next.”
