Interest rates have been on a downward trajectory for four decades now. The 10-year Treasury note topped out at 15.84% in 1981, while the consumer price index peaked at 14.8% in March of 1980 according to the Bureau of Labor Statistics. Federal Reserve Chair Paul Volcker set out to stop inflation. He did it and caused a recession, but a disinflationary boom followed. Bond yields tracked nominal GDP growth and inflation lower. There were several times where Treasury yields rallied only to resume their steady grind lower. This culminated with the 10-year Treasury reaching a closing low of 0.51% according to Bloomberg on August 4, 2020. Rates have moved higher but remain low absolutely at around one and a half percent, while the consumer price index is at a multi-year high of 6.2% year-over-year. The real rate, the nominal yield less inflation, is at an astonishing level of -4.8%. Interest rates are still low and have reached historically negative levels when adjusted for inflation (see chart).
Investors have struggled to find yield, and especially safe yield. High-quality, fixed-coupon bonds help to diversify portfolios, protect capital, and generate yield. While bonds still diversify portfolios and protect capital, their ability to produce income has waned. High-quality bonds currently earn less than inflation. They still protect capital, but if inflation remains at elevated levels, they will be unable to maintain purchasing power. This has led to a conundrum for investors and money managers. The part of the portfolio that was once the easiest part to manage to help clients reach their goals has now become the hardest.
NPP has adjusted to low interest rates by diversifying the bond portfolios. Bond portfolios that used to be comprised of fixed-coupon Treasury securities, municipal bonds, and high-grade corporate bonds are now diversified amongst sub-asset classes that bring different levels of protection to the portfolio and help the client with different aims. NPP still owns high-quality bonds in investor portfolios. We focus the longer parts of client portfolios on high-grade bonds. The ballast that they provide is necessary for balanced accounts. However, the percentage allocation has dropped. One of the chief benefits of high-quality bonds is that during recessions, their yields usually fall. Now that the coupons are so low, they are more sensitive to price movements higher (lower) when interest rates fall (rise), and the amount needed to hedge or diversify a portfolio are less than was needed when rates were higher.
We have increased the percentage of high-quality bonds that are invested in corporate or municipal bonds compared to Treasuries. We usually hold bonds that we purchase for clients until maturity. We believe the extra income compensates for the incremental risk. There are times when markets are really stressed, and high-quality bonds’ prices lag Treasuries and spreads rise. If you don’t need to sell, they make up for short-term pricing risk, with extra income.
While NPP does not believe inflation is going to be maintained at these elevated levels, we still think it is wise to guard against it in bond portfolios. We utilize Treasury Inflation-Protected Securities (“TIPS”) to reduce portfolios’ sensitivity to interest rates, generate yield and maintain purchasing power. TIPS benefit when inflation comes in above expectations.
NPP invests in sub-asset classes that we think offer an attractive risk/reward compared to safe bonds to generate additional yield and total return. These sub-asset classes do have higher credit risk but their yields and expected returns are higher than Treasuries, municipal bonds, and high-grade corporates. However, they tend to have less price risk than safe bonds in rising rate environments during economic expansions. NPP utilizes exchange-traded funds (“ETFs”) to invest in these categories with higher credit risk. We want our clients to have diversified exposure to these parts of the credit markets. The ETFs that we currently focus on include high-yield bonds and emerging market sovereign bonds denominated in dollars. None of these ETFs are a “permanent” portion of the portfolio. We evaluate credit spreads and economic trends to determine when these sub-asset classes should be included in portfolios and when they should not be, as opposed to high-quality bonds which will most likely be included in balanced portfolios. One of the main factors affecting the valuation of high-yield bonds is corporate profitability. Earnings are at an all-time high and this has helped keep defaults low.
Another reason for the current construction of NPP’s bond portfolios is that while stocks and long-term bonds have tended to show a negative correlation over the past few decades, that is not always the case. Negative correlation means that when stocks go up (down), safer long-term bonds such as Treasuries tend to go down (up). This helps to diversify risks and reduce losses during corrections or bear markets. This has not always been the case. During the 1960s and 1970s when inflation accelerated, the opposite was true. Bond prices tended to move in the same direction as stock prices. While we don’t expect inflation trends to equal the 1970s, the possibility of elevated inflation is higher than it has been for a while and we have adjusted our positioning accordingly. Overall, we have taken a little more credit risk while reducing the sensitivity of client portfolios to rising interest rates.
NPP’s equity investing process has not changed much as interest rates have dropped. Most accounts still have a portfolio turnover of about twenty percent meaning the typical stock is held for around five years. On the margin, lower rates have made it more difficult for some financial companies. Lower rates have arguably made “growth” companies relatively more valuable than value companies. NPP focuses on long-term themes when looking for stocks to buy and hold. Many of the “value” stocks are in industries that are secularly impaired, have not made the needed investments, and/or have too much debt. Higher interest rates would probably help banks, but there are a lot of companies and industries that are being disrupted where the level of interest rates has minimal effects on their underlying fundamentals. NPP prefers to own companies with good dividend yields, but it can never be the only factor. Frequently high dividend yields are a symptom of problems, not an indicator of value. We would prefer to have companies with moderate yields and growing cash flows to allow them to raise their dividends in the future.
It is important in today’s environment to keep an open mind and stay nimble. Central banks and governments policies of this type have not been attempted in the modern history of advanced economies. Central bank balance sheets have exploded while fiscal deficits surge. Nobody knows how this will turn out. NPP’s belief has been that it is best to take a little bit more credit risk to increase the expected returns, diversify the portfolio, and reduce duration risk. As always, we are monitoring market conditions and economic data and will reposition portfolios when we believe conditions warrant the move.