Credit spread compression helped dramatically minimize the negative impact of rising interest rates for income investors in February. As long-term rates rose higher in March, income investors continued to benefit from the natural “softening” effect of credit spread compression. In addition, some income portfolios benefitted further from other market forces during the month.
Since the start of 2021, long-term interest rates have climbed quite steadily, with the yield on the 10-Year Treasury rate jumping from 0.93% on January 1st to 1.45% on March 1st. By the last day of March, it had risen to 1.73%.1 The trend has sparked some concerns about inflation and led to a tiny bit of nervousness on Wall Street, although ultimately the stock market has risen rather steadily since the beginning of the year.2 The rise in rates has also prompted the usual dire warnings about tumbling bond values by some pundits—but only the ones who don’t really know much about bond investing.
The fact is, many income investors have done very well since the beginning of the year despite the well-known inverse relationship between bond values and interest rates (meaning when rates rise, bond values drop and vice-versa). They’ve done well because interest rates aren’t the only things that affect bond values, and they certainly aren’t the only things that dictate the performance of a diversified, actively-managed portfolio of bonds and bond-like instruments. Another important factor, as I explained in last month’s newsletter, is credit spread compression.
The Natural Softener
Remember, when we talk about bond values going down when interest rates go up, it needs to be the interest rate commensurate with that specific class of bonds. So, if an investor has a risk-free US treasury bond, it tracks the US treasury rate. However, if they have a triple-B corporate bond, the rate that affects their bond is the one commensurate with triple-B corporates, not the US treasury rate. That’s important because when interest rates fall, it’s typically because investors are worried about the economy, and when rates rise it’s because investors are becoming more confident. When one is worried, the amount of extra interest he or she might require to go from a risk-free US treasury to a corporate bond is likely to be much higher than if they were confident. That’s the credit spread, and when interest rates rise due to investor confidence—like they have been—risk premiums shrink or compress, creating a “natural softener” for actively-managed income portfolios.
So, even though the yield on the 10-Year Treasury rate has gone up by over eight-tenths of a percent since the start of the year, the rate on certain corporate bonds may have gone up by much less. For an investor, that means even though long-term rates overall have soared, their specific allocation has kept their portfolio values from dropping; the impact has been greatly softened, thanks to credit spread compression. To explain further, if one were invested in a 10-Year Treasury bond, the value of their bond has dropped by about 7% since the start of the year, mathematically speaking. However, if one is in a diversified portfolio of bonds and bond-like instruments, will they see their portfolio down by 7% in your April statement? No. Depending on their allocation and strategy, their portfolio may be down just slightly, or may not have dropped in value at all. It might even be slightly up on the year, and the softening effect of credit spread compression is only one reason why.
REITs and BDCs
Certain types of investments, such as Real Estate Investment Trusts (REITs) and Business Development Companies (BDCs), have performed extremely well since the start of the year for the same reason that interest rates have risen: investor confidence. Even though these vehicles carry more risk than individual bonds on a stand-alone basis, when peppered throughout an income portfolio, they can actually lower one's risk when interest rates are rising. Many income investors with a higher risk tolerance who are using a stock dividend strategy have also enjoyed strong year-to-date returns. So, again, while the current interest rate climate does create some challenges for income investors, it also shows how these challenges can be addressed with the right strategy, and even turned into opportunities in some cases.
Of course, the main point is although occasional drops in value in an income portfolio are almost inevitable due to market forces, with an income strategy investors know it’s only a temporary paper loss. Investors know that the par value of the bond is potentially more secure, and that they may count on getting their income return regardless of market conditions!
2“Wall Street Ticks Higher, Led by Tech and Smaller Stocks,” AP News, March 31, 2021