Junk may be a strong choice of words to describe asset classes poised to decline in the current market environment, but there are plenty of exposures much more common in many fixed income portfolios today which we would consider way more concerning than a fundamental approach to high yield. So what is the current environment?
As we wrote in May, we believe the Fed is unlikely to raise rates for an even longer period of time than the market is assuming already. Since we first published this opinion, the Fed has been vocal that any calls for it to act sooner because of unexpectedly strong recovery data are premature. We think that there may be some volatility on the horizon even as rates stay low as the trickle of critics now becomes a flood of pressure on the Fed in the future.
We also suggested that the Fed would not be terribly upset by the consequences of standing its ground, namely a steep upward sloping yield curve. We continue to believe this is the most likely scenario. However, we also recognize that the pandemic is far from over, and the actions of public officials are unpredictable (in most cases – some are depressingly predictable). Renewed concerns about the economy would have the opposite effect on the yield curve. That said, we don’t see the economic shock of 2020 repeating itself for two main reasons: (1) No two crises are the same, and it is the unexpected that triggers dislocations; (2) there seems to be little appetite anywhere for renewing policies which might risk recreating the economic and educational crises of the last 16 months. That said, we think there is risk of at least some public policy reaction, and we cannot predict how the markets might react even to a less severe set of restrictions.
Meanwhile, the corporate credit yield curve (i.e. interest rates + credit spreads) is remarkably flat. Issuers are not just refinancing debt at historically low yields; they are able to raise new debt and increase leverage at those same record low rates as well. Notably, many issuers already took advantage of the pre-pandemic low rate environment to refinance much of their debt and shore up liquidity, decisions which proved to be prescient as much of that liquidity was essential to weathering the brief 2020 economic seizure. As a result, today, it is not common to find issuers who feel the need to refinance debt for liquidity reasons. More often, we are seeing debt issuance for strategic reasons (e.g. acquisitions) or to lower a company’s cost of capital.
This means we are not seeing companies acting as aggressively to refinance their secured debt. Yields on secured debt are already lower than unsecured debt, and by our observation, are currently around the same levels as the yields available in the new issue market. This is why some might have observed that our portfolio statistics have skewed up the capital structure to the secured layer. This has not been a tactical risk decision (which we typically do not do anyway), but rather the result of our portfolio construction process, which places a heavy emphasis on evaluating not just volatility and credit risk but also opportunity cost.
Opportunity cost, put simply, is what you give up in opportunities in the future by making a decision today. As it pertains to corporate debt, this explains why we aren’t aggressive about purchasing newer bond issues. If we are not getting paid an appropriately higher yield to take on the longer-term risk, we prefer to earn that same yield for a shorter term and reinvest the proceeds at the time of maturity. There is risk to doing so, namely that yields may be lower in the future. First, we don’t believe a bet today on yields being lower three to five years from now is prudent, though perhaps we will be proven wrong. Second, we believe that the best risk to take in the fixed income markets right now is reinvestment risk.
In the case of our Duration Unconstrained Credit Strategy, we have positioned the portfolio with this in mind. When we include longer durations in that strategy, they tend to be particularly strong credit profiles and often in floating rate securities in which we can isolate the credit risk without taking on interest rate sensitivity. In the case of our Short Duration Income Strategy, selecting reinvestment risk is in many ways the inherent decision being made by our clients. That portfolio does not have a flexible duration mandate, so we will always position short and reinvest, regardless of the interest rate and credit spread environment.
In our opinion, investors should choose the shortest durations which allow them to achieve their income goals. In our experience, we have never been disappointed that we didn’t lock up our clients’ capital for longer. We have always found that having capital to deploy over time due to a continuous calendar of maturities and repayments over short timeframes has worked to our strategic advantage based on the portfolio we aim to deliver.
Unfortunately for many fixed income investors, we believe these risks expose broad market fixed income portfolios with longer durations, especially the intermediate term investment grade and mortgage-backed strategies found in most core fixed income portfolios. Even so, where one can take credit risk without interest rate risk, it must be done carefully and selectively given the potential for an unexpected economic hiccup. But yields are unlikely to rise, making it necessary for investors to seek higher income sources that are not materially exposed to inflation, the shape of the interest rate curve or the equity markets. Lastly, we believe it’s imperative that a portfolio be designed to mitigate rather than take risk if pandemic fears reemerge.
Balancing all of these potential outcomes and constructing a portfolio which can perform as expected regardless of the market environment is exactly the goal of our focus on reinvestment risk and rigorous fundamentals. We do not need to style drift to include asset classes outside of our core competency. We do not need to add hidden equity, SPAC or illiquidity exposure to our portfolios. We don’t need to expand our mandate and convince our investors the risk is the same when it is clearly not. To us, in this environment, that would be sign of junk in a portfolio.
By Venk Reddy
Originally published in Q2 2021 letter
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Zeo Capital Advisors is a fundamental investment manager with a short-duration credit mutual fund, a sustainable high yield mutual fund and separately managed accounts. Venk Reddy authored this piece and is the Chief Investment Officer and founded Zeo Capital Advisors in 2009.
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