January kicked off with a bang with the 10-year Treasury yield rising by 0.15% and breaching 1%. In this article we take a look at the different sectors that can perform well in a rising interest rate environment. Our own view is that it is unlikely for the rise in interest rates to become excessive given the Fed’s control over the yield curve. That said, it does make sense to position the portfolio in such a way so it continues to perform well in different market environments.
First, Some Perspective
One obvious approach to the recent rise in interest rates is to simply ignore it.
Despite a lot of anxiety about the impact of rising deficits on interest rates there is simply no empirical evidence that links rising deficits to rising interest rates. In fact, the relationship runs the other way around over the past two decades as rising debt levels have been associated with falling interest rates across the developed world.
Secondly, ultimately longer interest rates are a function of short-term interest rates. The Fed has indicated they plan to keep short-term rates anchored around zero for several years so a sharp rise in long-end rates will be that much more difficult.
Thirdly, the Fed has changed its inflation-targeting regime, which means it is only likely to respond if inflation holds above 2% for some time and then only if unemployment returns to low levels.
Fourthly, the Fed has been quite clear that they are not going to be happy to see rising interest rates tighten financing conditions and stall the recovery. Other countries have explicitly adopted yield curve control to manage the longer-end of the yield curve and the Fed has already explored this idea.
Finally, holding long duration assets which are sensitive to changes in interest rates is not just about getting the moves in interest rates right or wrong. It’s about getting compensated for taking duration exposure – if there were no compensation for taking duration exposure then a risk-averse investor would have no business in taking duration risk.
How are investors compensated for taking duration risk? There are 3 ways. First, and most obviously, investors get paid the underlying risk-free rate of the particular maturity – so investors in 5-year high-yield bonds receive the underlying risk-free rate of around 0.43% plus the high-yield credit spread.
Secondly, investors earn the rolldown on the bond which reflects the steepness of the yield curve. So, let’s say the 5y year-bond an investor holds has a yield of 5% and a similar 4-year bond has a yield of 4.5% – if the yield curve stays the same then the investor will gain 0.5% in a year’s time which in total would generate an additional 2% return (0.5% x duration of ~4). The yield curve is quite steep right now which makes this attractive.
Finally, long-duration assets are worth holding because rates typically fall during macro shocks which partially offsets credit spread widening.
A Look At Sector Performance
The chart below shows how various sectors have performed over the three days in early January that saw the 10-year yield rise by 0.15%.
What we see is higher-quality sectors have underperformed which makes sense as these sectors don’t have wide credit spreads that can cushion a rise in risk-free rates by tightening.
Local emerging market debt is not your typical high-quality sector, however, its reason for underperforming has to do with the strength in the USD which tends to coincide with higher US interest rates.
The sectors that have performed well are the high-beta sectors that are most sensitive to a reflationary market environment of higher growth expectations. These tend to be equity-linked sectors as well as higher-yield debt sectors.
Our consistent message for investors who are worried about rising interest rates is to tilt toward the following types of assets.
Higher-yielding credit assets will tend to be able to digest rising interest rates better than higher-quality assets because their credit spreads will typically tighten during a period of rising interest rates. This is because a rising interest rate environment is typically one of macro optimism and higher expected growth.
Investors can tilt towards higher-yielding assets both on a sector basis by allocating to high-yield bonds and bank loans but also on an intra-sector basis such as allocating to funds with higher-yielding holdings. For example, the tax-exempt muni CEF sector boasts funds with varying allocations to high-yield and unrated bonds. If we plot how all of the tax-exempt muni sector CEFs have performed on an NAV basis during the 3 days in early January when the 10-year Treasury yield broke through 1% and rose by 0.15% we see that it has been the high-yield focused funds (marked with a red star) that have performed the best.
If we extend this analysis and look at the performance of the broader tax-exempt muni CEF sector versus the subset of funds with a high-yield focus we see that the latter has outperformed by about 3.5% since the 10-year Treasury yield saw a low of 0.52% in early August, having more than doubled to 1.08% as of 7-January.
We continue to be overweight high-yield focused tax-exempt CEFs such as NMCO and CMU in our Muni Income Portfolio.
Shorter-maturity assets will tend to hold their value better during a period of rising rates due to their lower duration. Here, we like the iShares iBonds 2023 Term High Yield and Income ETF (IBHC) with a post-fee yield of about 3.6%. For investors willing to take a bit more risk we continue to like the OFS Credit Company 6.875% Series A (OCCIP) with a 2024 maturity and a 7.02% yield.
Floating-rate assets such as some RMBS securities and bank loans can withstand rising interest rates. Here, we like the Western Asset Mortgage Opportunity Fund (DMO) trading at a 9.6% yield and a 5.9% discount. The fund is overdistributing somewhat but it stopped its cycle of distribution cuts recently.
In the loan space we like the Eaton Vance Senior Floating Rate Trust (EFR) as a good overall pick in the sector as well as from potential uplift due to the Saba proxy battle. We also like the Blackstone Senior Floating Rate Term Fund (BSL) which boasts very attractive absolute and risk-adjusted returns in the sector and a repurchase program which should support the discount in the near term.
Funds with some equity-linked assets such as multi-sector funds with partial convertibles exposure like the AllianzGI Convertible & Income Fund (NCV) can perform well in a reflationary environment. The fund is also trading at an attractive discount of 8.8%.
Finally, pinned-to-par senior securities typically trade with a yield cushion which can absorb a rise in interest rates – which is something we have seen historically in practice.
Investors who are concerned about the impact of rising interest rates on their income portfolios have a number of strategies at their disposal. These include tilting to higher-yielding, shorter-maturity, floating-rate or equity-linked assets. Our own view is that the rise in interest rates is unlikely to be excessive given the Fed’s control over the yield curve, however, it does make sense to diversify across different types of exposure to ensure that the portfolio continues to perform across different market scenarios
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