Rising rates and volatile markets unsettled investors in 2022. The new resulting higher rate environment creates potential for seeking portfolio income.
Putting your cash to work in a higher rate environment
2.1: It is time to put excess cash to work
- Difficult market conditions increased the temptation to sit on excess cash
- But 2022’s turmoil has also created more possibilities for putting cash to work
- Our expectation is for interest rates to peak and inflation to decline before long
- We favor various short-term US dollar–denominated bonds and dividend grower equities
- Suitable clients may consider select alternatives and capital markets strategies
In 2022, the temptation to sit in cash was powerful for many investors. A rare simultaneous selloff in equities and bonds – as well as in many other asset classes – made the environment especially difficult. Cash did generate a small gain in nominal terms, making it the year’s second-best performer of ten broad asset classes – see Better long-term returns ahead.
With recession likely in the US and elsewhere in 2023, heightened uncertainty looks set to persist for now. Nevertheless, we believe that holding excess cash is risky. History has shown that trying to time an entry into the markets almost always fails. One reason for this is that missing out on the gains at the start of a market recovery can seriously dent long-term performance.
Amid the uncertainty, we see various ways to put cash to work and seek portfolio income. Indeed, we believe the conditions that made life so challenging for investors in 2022 have also created potential opportunities.
When it comes to certain US dollar-denominated bonds, however, it’s a different story. Yields on a range of assets have risen to levels not seen in some years. And with the interest rate hiking cycle perhaps nearing completion and inflation set to retreat in 2023, we see potential for Pursuing portfolio income with short- and intermediate-term bonds.
We also favor dividend growth equities, those with a track record of growing shareholder payouts throughout economic cycles. Over time, these consistent dividend equities have outperformed their more dynamic “growth” counterparts, rather like the tortoise beating the hare – see Why dividend grower “tortoises” may be core holdings.
For suitable investors, we see potential for seeking to turn equity market volatility into a source of income – see Why capital markets are more important than ever. Likewise, we set out the case for various private market strategies – see Alternative investments may enhance cash yields.
Higher interest rates have reshaped the investment landscape. Do not assume you will get security from holding excess cash. Rather, this is a time for putting liquid resources to work.
2.2 Pursuing portfolio income with short-term bonds
Yields have risen sharply across 2022. This has created income-seeking opportunities in US dollar short-term issues.
- Fed tightening has driven bond prices down sharply, driving short-term rates to their highest since 2008
- We believe the peak of the Fed hiking cycle may be coming into view
- As such, 2023 could bring opportunities to add shorter term, less volatile US-denominated bonds to portfolios
- Potential opportunities include shorter term US Treasuries, investment-grade credit, munis and preferred securities
Yesterday’s bad news may be today’s opportunity. US dollar-denominated fixed income suffered its worst total return in many decades in 2022. As of 22 November 2022, the Bloomberg US Aggregate Index total return for the year was negative 13.3%, with sub-indices representing US investment-grade debt negative by 16.1%, US high yield shedding 11.2% and the US dollar-denominated emerging markets debt index 17.6% lower. Even US Treasury Inflation Protected Securities (TIPS) were down 12%.
In sum, fixed income investors had nowhere to hide.
What caused the selloff? From a starting level of almost 0%, the Fed has raised its policy rates 375 basis points (bps) in an effort to choke off stubbornly high inflation, as of 3 November 2022. The market expects a bit more to come, with the Fed funds rate seen ending 2022 at 4.5%. Potential additional hikes in 2023 would take the terminal rate – the peak of the rate-hiking cycle – to about 5.0%.
Unlike the Fed, the market has priced in a very brief stay at the terminal rate in 2023, followed by at least one rate cut by the end of 2023 – Figure 1. We believe the impact of higher rates will hurt global economic growth as more cashflow goes to servicing debt, while also raising US unemployment as discretionary spending falls and sectors such as housing see a collapse in demand and construction.
As the Fed funds rate is likely to be around 4.5% by the end of 2022, we think the rate-hiking cycle will be nearing completion. As such, 2023 could bring a major opportunity to add shorter term, less volatile bonds to portfolios to lock in peak interest rates. “Shorter term” in this case means any issues with four years to maturity or less, although this will depend on your overall investment objectives and suitability. If rates keep rising, longer duration bonds will suffer greater losses.
The main reason we prefer shorter term instruments – in addition to their high historical yields – is that typically mark-to-market losses experienced in these instruments will be earned back once the bonds repay at maturity. Below, we present some alternatives to consider for investing in shorter term bonds.
US Treasuries come in many different maturities, but the shorter maturities offer high rates by recent past standards. Also, Treasuries offer more liquidity and generally more yield than bank certificates of deposit (CDs), which typically can pay 50-100bps less than the same maturity Treasury. In addition, US Treasuries of course are issued by the US government so, unlike bank CDs, do not carry credit risk.
These nominally high risk-free US government rates are also high compared to expected headline inflation as measured by TIPS – Figure 2.
Corporate bonds have higher rates than Treasuries, depending on their relative credit risk. From a repayment perspective, the least risky of these would be short-term investment-grade–related (IG) bonds issued by large, healthy companies with low levels of debt compared to earnings. In contrast, lower rated high-yield bonds with higher levels of debt to earnings generally have more repayment risk. The short-term IG index comprises debt of 1- to 3-year maturities, with low average duration – or price sensitivity to interest rate changes – of about 1.9 years. The IG index currently yields about 5.34%, almost 1% above comparable maturity (i.e., 2 year) Treasury bonds – Figure 3.
Besides investing in an index, investors may consider owning individual bonds, as there may be higher yield levels on individual IG-rated bonds for investors who understand the credit risk of the issuer. An index is an “average” of yields, so today there are numerous examples of high-quality credits that pay above index yields. For example, many of the largest US banks currently have bonds of less than three years’ maturity that yield near or above 5%. For those wishing to seek returns above those of the index, actively managed fixed income strategies are a wise consideration.
For investors eligible for the tax advantages, highly rated US municipals (“munis”) may be an interesting short-term fixed income opportunity. Munis generally pay a “tax-equivalent yield” near the equivalent Treasury yield – Figure 5 – but sometimes that tax-adjusted yield can be higher than Treasuries, as it was earlier this year. When that occurs, the tax-equivalent yield, especially for US taxpayers in high-tax states, can offer similar yields to investment grade, for government credit risk.
Floating/short-callable preferred securities
Investment-grade preferred securities may also add yield to portfolios, albeit with some additional risk. These securities are typically issued by banks, utilities and insurance companies. If the issuer went into liquidation, preferred holders would rank below owners of the company’s senior debt but just above equity owners when it came to repayment.
By design, most global preferred securities do not have a maturity date. However, most variable-rate preferred securities have the right to return principal to a preferred investor on a pre-determined “call” date. What if the issuer chooses not to call in the security and return principal at that time? Future coupon payments will either float in line with a benchmark such as SOFR or would be reset at prevailing Treasury yields. The details depend on the issuer and the preferred involved.
Historically, issuers have always refinanced preferreds when interest rates were falling rather than rising. As such, investors who received principal back today would have an opportunity to reinvest money back into the market at much higher yields. If issuers choose not to return principal to investors, most of these securities – which were issued when rates were much lower – would see their coupons either float or get reset at higher coupon levels. Preferreds can be bought both individually and through funds.
Seek yield amid higher rates
We believe that investors should review their asset allocations presently and consider adding highly rated short-term fixed income securities to a diversified portfolio. These may offer high income even after expected inflation, with low credit risk. In addition, should opportunities arise in 2023 in other asset classes such as equities or lower rated credit, short-term securities are typically liquid and can be sold quickly to generate cash to redeploy into these new potential opportunities.
2.3 Why dividend grower
Consistently dividend-paying equities may continue strongly into 2023. And while history points to weaker performance once investors anticipate economic recovery, we believe these income-producing assets should be considered for the long term.
tortoises may be core holdings
- Dividend grower equities have outperformed growth and other styles amid 2022’s turmoil
- Historically, over the long run, such equities have also performed better than their growth counterparts, like the tortoise outpacing the hare
- Early-stage recoveries, however, are typically the one period of the cycle where the tortoise typically loses to the hare
- Given our outlook, we would expect a shift in equity market leadership at some point in 2023 but continue to see long-term value in dividend growth for core portfolios
Amid 2022’s turbulence, the global equity market offered few refuges. Aside from certain commodity-related sectors, equities broadly fell as interest rates rose and earnings expectations for 2023 wilted. In this environment, equity investors have prized current income from firms with strong profits and a record of increasing payouts. They have favored such dividend-growing “tortoises” over capital growth-seeking “hares,” often speculative, early-stage ventures.
Of course, this follows a prolonged period where the hares dashed ahead of dividend-growing tortoises. Since the start of 2022, however, the tables have turned. The world’s most consistent dividend growers had outperformed the MSCI AC World Index by 7% as of 1 December 2022. And high dividend yielders – companies with the highest yields but without dividend growers’ track record of consistent payout growth – had outperformed by 8%. Likewise, dividend growers have delivered stronger returns than the tech-laden Nasdaq Composite, wsignificantly less volatility – Figure 1.
Quality equity income as a core portfolio allocation
On a multi-year view, dividends can be critical to total returns – Figure 2. Over the past 90 years, dividends have contributed nearly 40% of total returns in the S&P 500 Index. Dividend growth equities – as represented by the S&P Dividend Aristocrats Index – have outperformed the S&P 500 over the past 30 years with lower volatility. Even after this year’s outperformance, dividend-paying equities still trade at a 19% discount to broader market indices.
Seeking quality income, not just high income
Not all equity income is created equal. We believe quality equity income to be a core allocation within a diversified portfolio. We therefore not only seek out decent dividend yields but also consider payout sustainability. The best run companies generate enough free cash flow to increase dividend payouts while maintaining reinvestment in their operations. Firms that find themselves forced to choose between future business growth and current payouts face more skepticism, as few business models are sustainable without regular cash injections to keep assets up to date while retaining talent.
A quality investment approach also focuses on firm profitability, leverage and rate sensitivity, especially as higher interest rates will make debt costs more onerous in the years ahead. As always, qualitative factors like strong corporate governance and quality management teams are additional considerations that are hard to quantify but often align with long-term dividend sustainability.
The hare might surge ahead in 2023
We have high conviction in dividend growers as a core allocation. However, the one environment where this category tends to underperform is immediately before and in the early stages of a new economic cycle. There is risk that such conditions may arrive at some point in 2023, so we cannot simply extrapolate dividend grower equities’ 2022 performance throughout 2023.
True, we may see dividend grower “tortoises” continue to exhibit lower volatility and stronger performance for a time, particularly if a global recession takes hold next year. Thereafter, though, the most beaten-down parts of the equity markets – including firms with less of a track record of dividend payments – could rally hard as investors anticipate an eventual corporate profits recovery. The hare may be poised for a comeback, in other words.
What to do now?
At some point in 2023, we envisage early-cycle dynamics taking hold. If so, high-quality dividend growers may rally but less so than racier “hare” equities with high-growth characteristics, which have greater rebound potential given the extent of their selloff. We will likely shift our tactical asset allocation in favor of such shares once we think conditions are right. Throughout the economic cycle, however, we believe clients seeking both portfolio income and principal growth should seek to maintain strategic allocations to quality dividend payers throughout the economic cycle.
2.4 Why capital markets are more important than ever
Capital markets offer access to potential unique opportunities in 2023. Global uncertainty has unleashed greater volatility across many asset classes. Some capital markets strategies seek to convert this volatility into a source of income.
- Owing to geopolitical, economic and COVID uncertainty, equity volatility is well above average
- Amid high inflation, sitting in cash waiting to buy after further equity declines risks loss of purchasing power
- Certain capital markets strategies enable seeking an income while waiting to buy in at lower levels
- We believe “getting paid to wait” can be an attractive opportunity in today’s environment
War in Eastern Europe, intensifying US-China polarization, supply chain dislocation and pandemic aftershocks. Many of us sense that the world is more uncertain today than it has been for many years. And the truth is that financial markets reflect these concerns.
The volatility of the US stock market – as measured by the VIX Index, the market’s estimate of expected volatility in the S&P 500 Index – averaged 15% between 2015 and 2020. Since 2020, that number has risen to 24%, even after stripping out the extraordinary spikes in the early pandemic stages of March and June 2020 – Figure 1.
Such volatility extends beyond equity markets. As central banks have increased interest rates, fixed income markets and foreign exchange have reacted, with market volatility surging to levels not seen since before the global financial crisis in 2007-08.
The perception and reality of today’s volatility presents challenges for us as investors. When is the right time to invest? What if I invest right before another move-down? Should I just stay in cash for now?
Volatility as an investor opportunity
However, what if you could make this volatility work for you rather than against you? Consider two investors, Jack and Jill. Both Jack and Jill are keen to enter the equity market and have cash waiting on the sidelines to do so. Jack anxiously watches the markets, hoping for the market to drop to a level where he would like to buy. Jill, on the other hand, enters a strategy where she gets paid an income on her cash while she waits, in return for potentially buying into the equity market at lower than today’s level, where she would be happy to have exposure.
Six months later, the market has indeed dropped, and Jack invests. Jill automatically buys at this level also, and they both have the same equity exposure that they initially wanted. Jill, however, has income already banked.
But what if the market had never dropped and instead had gone up? Both Jack and Jill are left kicking themselves, as they have missed out on making their investments. But Jill can console herself, as she has income that she received as “payment for waiting,” as well as her originally invested cash. Jack simply rues his lost opportunity, having neither his desired equity exposure nor any income.
What to do now?
In an uncertain market, strategies such as “getting paid to wait” present a compelling proposition for suitable investors with undeployed cash. With inflation at double-digit levels in many countries, the cost of holding cash has risen dramatically. Investors who refrain from investing now for fear of a further leg down in equities should consider the erosion of their cash’s purchasing power.
Suitable investors seeking to increase their equity exposure should consider their cash position and explore appropriate capital markets strategies for putting it to work. Such opportunities may offer above-average yields or the opportunity to gain exposures to markets at more attractive levels, a trade-off worth considering for sophisticated, suitable investors.
2.5 Alternative investments may enhance cash yields
An indiscriminate selloff across fixed income may have created potential opportunities in income-generating alternative investments. For suitable investors, we believe certain strategies may offer diversified ways to enhance portfolio income.
- The great bond selloff has expanded the universe of debt trading at stressed or distressed levels
- Given difficulties in issuing fresh debt, some companies may have to find other ways to raise capital
- Forced selling of debt by certain holders creates potential opportunities for specialist strategies
- We believe managers specializing in credit underwriting, the ability to facilitate capital solutions, and those with distressed restructuring expertise may be best placed for opportunities
While painful for traditional investors, we believe fixed income market turmoil in 2022 has created a favorable landscape for alternative managers going into 2023. Specifically, we see potential opportunities to take advantage of volatility, capital shortages and episodes of outright stress and/or distress. Specialist managers will use their expertise in underwriting new issues and pursuing event-driven strategies in both public and private credit markets.
Lately, the universe of debt trading at stressed and/or distressed levels has expanded – Figure 1. This is a result of tighter central bank policy, restrictions on the deployment of bank capital, higher bond yields and widening credit spreads – the latter owing to recessionary fears. We see this bond selloff as broadly indiscriminate, with investors overlooking firm-specific factors that may influence when and how borrowers repay their outstanding debt. As a result, we believe that managers who have insight into issuer quality and potential capital structure events – including refinancings, debt exchanges and outright restructurings – may be able to generate strong total returns.
Spooked by this shakeout and the uncertain outlook for corporate profits, certain capital markets have largely closed to some companies wishing to raise capital. Issuance of high-yield bonds and loans through the end of the third quarter of 2022 stood at just 78% and 61% below levels respectively in the same period in 2021 – Figure 2. Given such severe debt-issuance constraints, many companies may need to explore alternative ways of raising capital.
Active alternative investment managers can provide anchor capital for a new debt issue and initiate exchanges of public debt directly with issuers where borrowers receive maturity relief in return for higher yield and/or additional collateral. And private credit managers can work with companies on private financings where terms and collateral packages can be negotiated to provide favorable yields as well as covenants and seek downside protection.
Opportunistic and special situation credit investing
Some managers seek to take advantage of forced selling by debt holders. For example, certain mutual funds may experience investor outflows that leave them needing to raise capital, therefore selling debt at prices that entice opportunistic capital from hedge funds or private equity vehicles.
Also, some banks have lately been forced to sell loans they committed to make to private equity managers. To clear this arranged debt off their balance sheets, such banks have had to offer substantial price discounts on quality debt that would have previously been syndicated at or near par.
These cases highlight the potential opportunity to acquire good credits at distressed price levels. For now, of course, default rates remain low. However, the impact of higher yields and slowing economic growth may well be rising default rates over the next year – Figure 3. In 2020, the speed of the pandemic-induced market decline and the central bank reaction led to a short-lived distressed cycle. This time, we believe it possible that corporate defaults stay elevated for longer. If so, it would create an extended window for specialist managers to take troubled companies through the restructuring process.
|Begin||End||HY index drawdown||HFRI forward 24M return|
|Global financial crisis||31 May ‘07||30 Nov ‘08||-33.2%||34.8%|
|Early COVID pandemic||31 Jan ‘20||31 Mar ‘20||-13.1%||48.2%|
|Dot-com bust||30 Apr ‘00||31 Jul ‘02||-12.0%||46.3%|
|Early 90s recession||31 Jul ‘90||31 Oct ‘90||-11.2%||66.0%|
|Energy sector’s wave of defaults||31 May ‘15||31 Jan ‘16||-9.8%||27.8%|
Table shows five significant selloffs in high-yield bonds and the subsequent 24-month returns of the HFRI ED Distressed/Restructuring Index.
Previous periods of market stress have translated into opportunities for hedge fund managers with credit market expertise. We examined the high-yield bond market’s five biggest declines: four recessions including the global financial crisis as well as the 2015–2016 wave of energy sector defaults. Following those episodes, the average 24-month return for the HFRI ED (Distressed/Restructuring Index) was approximately 45% – Figure 4. And that is simply at the index level; in periods of credit market stress and distress, we believe that skillful manager selection may translate into return capture.
What to do now?
Given today’s heightened level of uncertainty, we do not see a case for being overweight high-yield credits in general. Instead, we favor selective exposure via skilled bond picking managers, who seek to exploit the wide dispersion in the best and worst performing bonds. We believe those specializing in credit underwriting, those able to work with companies on capital solutions and those with distressed restructuring expertise may be best placed to achieve this.
In the public markets, we prefer managers who can evaluate absolute and relative value, and who focus on events that will seek idiosyncratic returns and upside capture along with downside protection.
In private markets, we believe that managers with flexible capital may be rewarded, allowing them to evaluate financing solutions across the continuum while patiently awaiting the emergence of potential distressed opportunities.
Managers without the requisite scale may be at a competitive disadvantage in this market. We have seen this occur in 2022 in priming transactions. These are where big new or existing lenders that negotiate directly with the company receive new debt with additional collateral that is structurally senior to existing debt; i.e., it has a higher priority of repayment if the borrower goes into liquidation. Also, in a heightened environment for defaults, managers that do not have restructuring expertise and are unable to negotiate favorable outcomes for their part of the capital structure will likely be left with lower recoveries on distressed debt.
Suitable investors should consider their investment objectives and how these potential opportunities might complement their asset allocation.
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