An update on fixed income

September 11, 2012

The past several years have been good for bond investors as well as those who own bonds in balanced portfolios. Interest rates have fallen, pushing bond prices up. Fundamentals in both the corporate credit and mortgage backed securities markets have improved. Lately, though, navigating the bond market on behalf of UCF investors has become more challenging as the general level of interest rates is now lower than most other times in history.

Andrew Russell, Head of Fixed Income Investments

Andrew Russell, Head of Fixed Income Investments

In the near term it does seem that slow economic growth and low bond rates will persist. However, given great market uncertainties being fostered by unpredictable government and political activity, we just aren’t sure.

Why are current rates so low? For the past thirty years bond yields have generally been falling, in part due to low inflation. More recently investors worldwide have been purchasing US Treasury securities (pushing prices up and rates down) as they seek to put their money in one of the safest investments possible, even though their expected return amounts to only a penny or two on the dollar. Thankfully, inflation remains contained for the moment; but the tremendous budget deficit in the US suggests that this status quo won’t last forever.

The other reason rates are so low? Ben Bernanke and the Federal Reserve believe that lower borrowing costs will help revive the sluggish economy. They also expect that extremely low yields on less risky fixed income securities will encourage investors to seek higher returns elsewhere, i.e., in the stock market. (By taking more risk and buying equities, investors provide companies greater access to capital which allows them to expand — creating more jobs and boosting economic growth.) Additionally, many investors remain concerned about the outlook for the global economy, the housing and jobs markets here at home, and the political goings-on in Washington. These concerns result in folks saving more and spending less — the exact opposite of what a struggling economy needs to get going again.

What are we doing to prudently improve fixed income returns in this low rate environment while preparing for the possibility (however unlikely at the moment) of higher interest rates in the future?

  1. We have reduced the sensitivity of the portfolio to changes in interest rates because we don’t think rates have that much farther to fall. We’ve raised our cash position, believing we will see better opportunities ahead, while holding on to our longest maturity bonds where yields remain the highest.
  2. We’ve drastically reduced our exposure to US Government bonds — Treasury securities in particular — in favor of higher yielding investment grade corporate bonds whose credit fundamentals look stable or are, ideally, improving.
  3. In a prudent and appropriate way, we’ve invested in emerging markets bonds — a new allocation that has already benefited the portfolio by increasing its return. This allocation also serves to further diversify the risks among the portfolio’s holdings and to further reduce the portfolio’s sensitivity to the possibility of higher rates in the US.

Looking forward, our main challenge to providing a consistently positive respectable return on the Fixed Income Fund is the overall low level of rates and the possibility of higher interest rates in the future. The more quickly rates rise, the more detrimental to current returns they will be. As always, we remember that principal preservation is the priority and that it is investments in bonds that allow investors to sleep well, or at least better, at night.

By Andrew Russell, Head of Fixed Income Investments

 
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