Our ongoing Q&A series features Carillon Tower affiliate managers sharing their diverse investment philosophies and thoughts on the market.
Interest rate activity and the return of volatility have focused attention on income markets. Eagle Asset Management Managing Director James Camp shared his thoughts on strategy in this space.
The Fed has stood down as a result of slowing inflation growth and declining economic data. We expect the Fed will capitulate again in September with another rate cut; however, we do not believe this is a prelude to continued monetary accommodation in the form of lower interest rates on the short end. Key portions of the yield curve have inverted: The spreads in yield between the 2-year and 10-year U.S. Treasury note inverted in mid-August, and the 10-year U.S. Treasury note and the 3-month U.S. Treasury bill has experienced a period of sustained inversion since May. The bond market is telling the Fed to slow down and it appears for now that they are listening. Without a material uptick in inflation and economic growth, we find it hard to believe that long-term interest rates will move materially higher.
Yields across the globe are collapsing. Economies in the Eurozone are rolling over and teetering on the verge of negative growth and growth prospects in the U.S. have come down. That is not to say there is an imminent threat of recession, but we have a less robust growth environment. Central banks appear once again to be taking the reins of economic policy, which we do not believe is in the structural best interest of economic growth going forward.
High-yield and leveraged loans are areas we believe fixed income investors should avoid. Spreads have continued to tighten, so investors are not getting the proper compensation for the incremental risks they are taking. We refer to these securities as “equity-lite,” since their risk and return profile has more closely mirrored that of stocks throughout history. The covenants in these bonds protecting bondholders are by and large very weak. When there is a crack in credit, the potential for loss may be higher than in previous downturns. Unfortunately, many investors are not aware of the additional risks they may take for such a meager increase in yield.
Some of the problems we’re seeing in high yield also extend to the lowest quality names in the investment grade category, namely the BBB space. There has been a proliferation of names in the BBB space, with more than half the corporate bonds currently in the Bloomberg Barclays Corporate Bond Index hovering one step above junk. The near-zero risk-free rate environment over the past decade incentivized many companies to lever up. On the plus side, there are select companies with attractive yields that get lumped into the same bucket as some of these poorly managed companies based off of a credit rating that may have been given out by a credit rating agency years ago. Credit research and active management can help identify those companies that are utilizing a disciplined capital allocation policy with specific guidelines for reducing or maintaining leverage.
Interest rates are still very low compared to long-term historical averages. Meanwhile, companies have been increasing their dividends at a rapid pace due to the cash windfalls from fiscal stimulus and an expanding economy. This has created unique opportunities where investment-grade companies have stocks that out-yield their bonds. For investors who are comfortable with a company that fits this criteria, we think it makes sense to buy that company’s equity since it provides the potential for higher dividend income as well as possible upside potential due to stock price appreciation. These situations are not the norm, but they have become more common given the current low-interest-rate environment. We believe a blend of bonds, preferred securities and carefully selected common stocks can provide similar income and total returns to high-yield bonds, but with much lower risk.
In addition to our concerns surrounding corporate leverage, we’re starting to see a number of macroeconomic indicators roll over. Companies in the manufacturing and industrial space have seen a continued period of weakness, and we believe if this trend continues, it has the potential to impact companies more broadly in other industries. This combination of elevated corporate leverage and slowing corporate profits can benefit stock and bond pickers with an eye towards quality.
During period of market stress, we tend to see outflows from some of the passive vehicles that both create pressure on the net asset value for those products and give us the opportunity to buy inexpensive paper from those funds. I think active management in fixed income has always had a leg up relative to equity counterparts. We are confident that security selection in both the tax-free municipal space and the corporate space is going to be of paramount importance for performance going forward.
Eagle Asset Management provides a broad array of fundamental equity and fixed-income strategies designed to meet the long-term goals of institutional and individual investors. Eagle’s multiple independent investment teams have the autonomy to pursue investment decisions guided by their individual philosophies and strategies.
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Carillon Tower Advisers provides support services, including marketing and sales, to affiliated advisers. Carillon Tower Advisers’ affiliates (Eagle Asset Management, ClariVest Asset Management, Cougar Global Investments, Scout Investments and Reams Asset Management, a division of Scout Investments) manage a broad range of investment vehicles, including separately managed accounts, mutual funds, closed-end funds, UCITS and other types of products.
Risks associated with Fixed Income investing: many investors consider bonds to be “risk free” investment vehicles. Historically, bonds have indeed provided less volatility and less
risk of loss of capital than has equity investing. However, there are many factors that may affect the risk and return profile of a fixed-income portfolio. The two most prominent
factors are interest-rate movements and the creditworthiness of the bond issuer. Bonds issued by the U.S. government have significantly less risk of default than those issued by
corporations and municipalities. However, the overall return on government bonds tends to be less than these other types of fixed-income securities. Investors should pay careful
attention to the types of fixed-income securities that comprise their portfolio, and remember that, as with all investments, there is the risk of the loss of capital.
This material may include forward-looking statements. These statements are not historical facts, but instead represent only beliefs regarding future events, many of which, by their nature, are inherently uncertain. You should not place undue reliance on forward-looking statements as it is possible that actual results and financial conditions may differ, possibly materially, from the anticipated results and financial conditions indicated in these forward-looking statements. There are uncertainties, unknown risks, and other factors that may cause actual results, levels of activity, performance or achievements to be materially different from any future results, levels of activity, performance or achievements expressed or implied by these statements.
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