Navigating fixed-income's roiling waters Navigating fixed-income's roiling waters\images\insights\article\kayaker-rapids-small.jpg November 3 2021 November 3 2021

Navigating fixed-income's roiling waters

The case for an active approach to the short end of the bond market.

Published November 3 2021
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Beneath the surface of the fixed-income market, there is a churn in short-term corporate bonds that may cause unease for some. We see opportunity. Why?

First the background. The low, relatively flat yield curve in recent years has resulted in companies refinancing short-term debt to take advantage of attractive rates further out on the curve. With tighter monetary conditions on the horizon that refinancing is now happening in earnest before the curve becomes too steep and borrowing costs rise, especially in investment-grade short-term credit.

The refinancing is reducing the investable universe at the margin and removing many higher coupon, higher income-generating bonds. As active managers in the short end of the bond market, we don’t find this to be a problem; in fact, we embrace it. Even though corporations have on balance paid down debt taken on during the worst of the pandemic and reduced leverage, thanks to robust earnings and cash flow generation, they keep issuing new debt. It’s an environment that demands rigorous research to sift through and uncover opportunities many others don’t see. We often find them in the BBB- segment.

To many, securities rated BBB- dwell in precarious terrain. But to experienced portfolio managers and analysts, this is fertile ground not a reckless investment. Many of these companies have strong balance sheets and solid growth prospects and want to maintain their investment-grade ratings. As the next step down in credit ratings puts bonds in high-yield territory, increasing their borrowing costs, most corporations will go to great lengths to avoid that rating downgrade. Simply put, IG’s lower tier often is less risky than the three letters and minus sign may imply, if you know where—and how—to look. This is particularly the case in the low duration space.

Against a sound U.S. economic backdrop, enhanced by gobs of federal fiscal stimulus, corporate credit conditions are improving, as evidenced by falling leverage and, per S&P, credit upgrades setting a new high in 2021. That said, the supply hiccup caused by the pandemic has exposed fault lines some companies are trying to cover by using the debt issuance to help fund expansion and capital expenditures.

Recently, we have been finding value in companies with leading market positions and technologies; those new to the investment-grade market, either rising-star (former high-yield issuers) or companies spun out of larger ones; and those familiar to our analysts from many years of covering them. For example:

  • Aircraft leasing businesses that airlines are using to navigate changing needs and customer preferences
  • Telecom and wireless corporations that have merged to create attractive alternatives to market incumbents
  • Health and life science companies acquiring businesses to enhance product offerings during the pandemic

We know the companies, their personalities and their quirks. Over time, this helps us to gain confidence in management and the companies they run. After living through numerous credit cycles, including those with higher inflation, we believe we have a handle on the current environment.

Tags Markets/Economy . Fixed Income . Interest Rates .

Views are as of the date above and are subject to change based on market conditions and other factors. These views should not be construed as a recommendation for any specific security or sector.

Bond prices are sensitive to changes in interest rates, and a rise in interest rates can cause a decline in their prices.

Credit ratings of A or better are considered to be high credit quality; credit ratings of BBB are good credit quality and the lowest category of investment grade; credit ratings BB and below are lower-rated securities ("junk bonds"); and credit ratings of CCC or below have high default risk.

Duration is a measure of a security's price sensitivity to changes in interest rates. Securities with longer durations are more sensitive to changes in interest rates than securities of shorter durations.

High-yield, lower-rated securities generally entail greater market, credit, and liquidity risk than investment-grade securities and may include higher volatility and higher risk of default.

Yield Curve: Graph showing the comparative yields of securities in a particular class according to maturity. Securities on the long end of the yield curve have longer maturities.

Federated Investment Management Company