We wanted to take this opportunity to update you on recent market events, especially in the fixed income market, and our strategy to protect UCF portfolios against the possibility of higher interest rates.
The duration of the United Church Funds Fixed Income Fund remains at 4.5. Duration reflects the sensitivity of the Fund to changes in interest rates. The average maturity of the Fund is 6.5 years. The current allocation in the UCF Fixed Income Fund is 79% Core Fixed, 13% Bank Loans and 8% Emerging Markets local currency debt. Importantly, roughly 20% of the Fund’s securities have floating rate coupons, which also protect against higher rates. Notably, the majority of the securities in the Fund have maturities of less than 10 years.
Given the challenge of predicting the path and speed of future interest rate changes, we have positioned the Fixed Income Fund with duration sufficient to earn an income reasonable enough to help offset some of the decline in principal value that would result from higher interest rates. This strategy also allows us the flexibility to add value via portfolio construction techniques and trading strategies. Of note, even though the yield on the 10-year Treasury rate nearly doubled from the beginning of May to the beginning of September (1.62% to 3.00%), the trailing 1-year return of the Fixed Income Fund (before fees) is about -1.00%. This is due in large part to the offsetting coupon interest generated during the period. A loss of 1% during a time when interest rates doubled more quickly than any other in the past 50 years encourages us. The point being that we need not be overly alarmed by higher rates in the future, as long as they occur over enough time to allow coupon income to offset the falling prices.
The point being that we need not be overly alarmed by higher rates in the future, as long as they occur over enough time to allow coupon income to offset the falling prices.
To taper or not to taper
Regarding the “taper” (reduction in stimulus via bond purchases by the Federal Reserve (Fed)), while the media would have led many to believe that a major taper was in the offing, behind the scenes market participants were about evenly split as to whether the Fed would begin to taper or not. Economic data over the past several weeks, and in particular the most recent unemployment data, have been weaker than expected. Add to this the economic slowing effects of the massive rise in interest rates (mortgage refinancing activity has slowed dramatically, calling into question the momentum of the housing recovery) and the impetus for tapering becomes less clear. Also, besides rising oil prices there hasn’t been much economically to concern the Fed regarding rising inflation expectations. This slowing economic data and lack of concern about rising inflation gives the Fed a lot of flexibility regarding the “when” and “how much” to taper. When you consider that US economic growth over the past year has been marginal at best, you realize that the economic reasons to taper are few. Yet, the Fed has gotten itself into a risky situation with its quantitative easing and it will ultimately have to figure a way out! Although the announcement to taper or not could have gone either way, the market in terms of prices was expecting a taper of some kind. Both risk assets and Treasuries rallied significantly when that didn’t happen. As before the announcement, few investors believe that short-term interest rates (less than two year maturities) will rise much any time soon. Longer-term rates are much more dependent on future economic news, in particular the monthly employment report, which will have a heavy influence on the timing and degree of any tapering.
While we expect interest rates to further normalize over the longer-term, we are in the camp that 10-year yields will remain in the 2.75% – 3.00% area for the remainder of this year. Similarly, economists are now changing their projections for the taper. Many now expect the first taper to begin possibly in December and for the official interest rate hike not to begin until 2015. Before interest rates can move markedly higher again, the market must first deal with the debt ceiling concerns. Also, if rates were to move significantly higher than 3% right now, the economy, which continues to muddle along, would be in even worse shape. In sum, rates are likely to be higher in the future at some point, but by how much and how soon is very much undetermined.
Looking ahead
As for what we are doing to position the Fund going forward, we recently increased the Fund’s emerging market debt exposure to 8% from 6%. This decision was value-driven. The sell-off in emerging markets debt was mostly technical in nature as investors who had sought higher yields in overseas markets became concerned that the value of those foreign currencies would suffer as a result of the Fed taper. We felt that this sell-off was overdone so we modestly increased exposure. Sure enough, with the Fed not tapering emerging market, debt prices rallied sharply. The EMD component of the Fixed Income Fund has recovered in September, returning nearly 4% month-to-date.
We will continue to keep you informed about the important subject of interest rate movements and the impact they have on your UCF portfolio.
By Andrew Russell, Head of Fixed Income Investments