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Many fixed income investors with traditional investment-grade bond portfolios were likely disappointed by their performance in 1Q’21. This is understandable, because for the 5 years through 2020, the average annual investment-grade bond returned over 6.5%, whereas in 1Q, that return was -4.6%. Investors may not appreciate that the average investment-grade bond has a maturity of over 12 years, which results in substantial interest rate risk (duration). Consequently, as interest rates increased in 2021, investment-grade bond prices declined notably. Fixed income investors need not be discouraged: Investment grade fixed income can still contribute positively to a portfolio over the long-term if investors keep duration shorter and pivot away from familiar, large company bonds into lesser known but still high-quality issues. This has been our primary focus for fixed income strategies at ACM for the past several years.

We are carefully constructing investment-grade portfolios with more yield than a portfolio of average bonds with a similar maturity, and we are doing so while taking less interest rate risk (duration). The proof is in the pudding. In 1Q’21, the ACM investment-grade portfolio strongly outperformed: it was down approximately 1.3% (net of fees) while the average investment-grade bond returned -4.6% and the average intermediate investment-grade bond returned -2.2%. ACM’s outperformance was driven by selecting credits that we expected to benefit from the economic recovery and its commensurate reduction in risk premiums (credit spreads). Since yield = (risk-free) interest rate + credit spread, this credit spread compression offset some of the negative impact of interest rate increases and consequently helped to support the prices of those bonds. The ACM portfolio also benefited from having a lower duration (interest rate exposure) than the intermediate benchmark and around only half the duration of the average investment grade bond, implying we took less interest rate risk.

Going forward, we will continue to position the portfolio to outperform in a rising rate environment. Interest rates may rise further, because of the strong economic recovery. When fear is high, many investors hide in Treasuries for safety, which pushes down Treasury yields (remember Treasuries have no credit spreads/risk premiums). However, several stimulus packages combined with the Fed’s actions and an accelerated vaccine rollout to help the economy recover. Recent economic data is showing jobs, confidence, and spending are trending positively and an eventual return to pre-Covid levels is now a realistic possibility. The improving economic outlook has bondholders focusing more on growth prospects and inflation concerns rather than fear.

Our “creatively constructed portfolios” incorporate selections to reduce vulnerability to such interest rate increases and this pushes us away from only owning the highest quality, long-dated bonds, Treasuries, or simply the average investment grade bond. Finding those selections puts us deep in the weeds of corporate credit analysis. We regularly evaluate hundreds of bonds and preferreds, and from these we select a small percentage. While most fixed income investors are likely not intending to make a big interest rate bet, many are unknowingly doing just that if they are buying a basket of fixed income funds or only the highest quality bonds.

The fixed income securities we purchase generally satisfy at least one of the following three criteria: the security provides a yield higher than the average investment grade bond with a similar maturity, the security has the potential to trade at a tighter spread (lower risk premium), or the security is an attractive preferred or convertible security rather than a traditional corporate bond. To implement this approach, we focus on BBB and BBB-rated fixed income securities. The lowest two tiers of investment grade, BBB/BBB-, where thorough credit research pays off the most, still allows the investor to own investment-grade securities. To be clear, we do not limit ourselves to BBB/BBB- rated securities. When we occasionally find higher-rated securities with attractive yields, we purchase them. Our thorough credit research allows us to find securities that are often under-appreciated, so when the market catches on to the fundamental story, these securities will often rise in price (trade at a tighter credit spread/small risk premium). Finally, we also purchase multiple investment grade preferreds that we think provide attractive additional yield, typically well in excess of most investment grade bond yields. Among preferreds, being exceedingly picky is essential to safeguard against downside risks. Convertible bonds are often neglected by traditional bond investors, but can also be extremely attractive, especially during market downturns such as in 2020. In 2020, we purchased multiple securities that we were able to later sell at sizable gains. Investors should be aware that each preferred is quite unique, and even preferreds from the same issuer almost always have different terms.

In the current environment, an investment-grade fixed income portfolio with an attractive yield will always require some degree of interest rate exposure. The obvious options with minimal interest rate risk exposure, unfortunately, provide minimal yield. An extremely short-dated investment grade portfolio comprised of 1 year investment grade bonds will yield less than 0.4% (that is a CD type of yield.) Another safe option is a floating-rate investment-grade bond portfolio, but this also offers a low yield because investment-grade risk premiums/credit spreads are low and very short-term rates are approaching zero (reminder: yield = interest rate + credit spread). Building an interest rate resistant fixed income portfolio can potentially provide you with a higher return and also likely lessen your potential interest rate downside. Our creative approach has led to solid outperformance in 2021, and we believe it will continue to be a solid strategy going forward.

For those investors seeking additional yield and willing to withstand a bit more volatility, we offer a fixed plus strategy. This strategy generally includes approximately 20-25% non-investment grade securities and correspondingly provides a higher yield.

Bonus: Does an additional 1% in fixed income really matter?
To give you some real-world context, a 1% return will yield 10.5% profit over 10 years’ time while a 2% return will yield 21.9%. On a $300,000 initial investment that is an additional $34,300, which is enough to buy a new car every ten years, which is not a ‘sleepy’ amount of money. If an investor has a larger account or a longer time horizon, the impact of an additional 1% becomes even more significant.

About the Author

Kevin Kelly

Kevin Kelly

Mr. Kelly is the Portfolio Manager of Fixed Income and a member of the Investment Committee. Before joining ACM, Mr. Kelly was a portfolio manager at Verition Fund Management in New York, NY where his duties included managing a long/short…
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The economy is now in full sprint, after being “Off to the Races”, as we wrote a month ago. Payroll jobs surged by 1.07 million in March, including upward revisions to prior months, and additional mega-sized jobs gains are likely in the coming months, as vaccinations continue to roll out rapidly and the economy reopens. Consistently, stocks had a terrific month with the S&P gaining 4.2%, while bonds got crushed, as we’ve been warning, with the 10-year Treasury soaring 81 basis points in yield (admittedly even faster than we anticipated). We expect all of these trends to continue in the second quarter.

The macro story is actually quite straightforward. As vaccinations inoculate ever larger fractions of the population, governments will permit more businesses to reopen, and people will be anxious to get back to their lives. This is evident in a very wide range of economic statistics. It was reported on Friday that almost 4 million doses were administered in a single day. Age limits to qualify for vaccination are being reduced rapidly across the nation, even as vaccine supplies ramp further. Nearly one-third of our total population has already received one dose and nearly one fifth is fully inoculated (and more are protected when taking account of those who have recovered from Covid).

Activity is rising towards normal, even if it isn’t there quite yet. TSA checks already exceed 1.5 million daily and airlines report that bookings are rising sharply. Delta Airlines is now selling middle seats again, the last airline to do so, and more airlines are recalling pilots and bringing parked planes back into service. Gasoline consumption is nearly back to pre-pandemic levels and retail sales are now higher. Attendance is rising at restaurants, bars, gyms and spas, the last places we expect people to be comfortable. While demand is strong, production increases are being constrained by a lack of workers and supply shortages, with autos a notable example. It will take months, if not quarters, to work out all the kinks in the supply chain, but the economy will enjoy very strong ongoing impetus to growth from backlogged demand. In addition, the recent $1.9 trillion fiscal stimulus package will add gasoline to the fire, with a sizable infrastructure package still looming, and monetary policy still adding billions in liquidity to the financial markets each month.

It is entirely appropriate to wonder if it is all too much, too quickly. The 6.0% unemployment rate reported for March is likely to fall below 5% by the end of the year and the inability of firms to hire as quickly as they wish could push up labor costs and inflation. Some rise in inflation is expected because of base effects. In March and April 2020, inflation was extremely soft, reflecting the shutdown of large swaths of the economy. So, year over year comparisons will soon become quite unfavorable. This “surge” in inflation is widely understood and the Fed has stated it will prove to be temporary. And, the Fed might be correct. But what if it masks a more general upward pressure on inflation because of the robust expansion? That won’t become clear until the second half of the year when these base effects die out.

Monetary policy is still focused on promoting a rapid recovery. The Fed’s objectives have changed and they are now seeking definitive evidence that inflation will remain consistently above 2%, since it has been below their objective for a long time. The Fed suggests it knows how to rein in inflation when that time comes. But having lived through the high inflation period of the 1970s, I recall all too well that high interest rates for a protracted period of time were needed to quell the inflation inferno that had been unleashed. With fiscal and monetary policy highly focused on promoting a very vigorous recovery and with government plans to introduce major new social programs second only to Johnson’s Great Society, the risks seem mostly one-sided towards higher inflation.

The investment implications of current economic conditions for markets are as positive for stocks as they are negative for bonds. The strong economic recovery will be evident in corporate earnings reports, which will begin to emerge for the first quarter within the next two weeks. Estimates are mostly being revised higher and we expect stocks to perform well following a 7% gain in the S&P in Q1. In contrast, such widespread evidence of economic strength is likely to hurt bond prices. TLT, the long-term Treasury ETF, declined over 14% in value in the first quarter. Even with the recent rise in interest rates, 10-year Treasuries yield only 1.7%, still well below the Fed’s inflation objectives. We have carefully positioned for cyclically sensitive stocks to perform especially well, while keeping our bond maturities short to protect against rising interest rates.

About the Author

Dr. Charles Lieberman

Dr. Charles Lieberman

Dr. Charles Lieberman is the Chief Investment Officer and co-founder of Advisors Capital Management, LLC. Dr. Lieberman began his professional career as an academic at the University of Maryland and Northwestern University. After five years in academia, he joined the…
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As humans evolved from small groups of nomadic hunter-gatherers towards larger and more complex societies, they were inevitably confronted with the need for mediums of exchange. Two forms of money arose from this need: representative money and commodity money.

Representative money, which pre-dates the invention of coinage, is money that has no intrinsic value but represents a claim on something of value. This form of money facilitated domestic trade as divisions of labor proliferated within a community. For example, a farmer could deliver the season’s harvest at a central warehouse and receive in exchange tokens which symbolized claims to a portion of goods from the warehouse. These tokens could then be used to trade for other goods in the market or used for payment to workers.

Commodity money is money that has intrinsic value derived from the commodity from which it is made. This form of money was important in foreign trade, in which representative money tokens tied to the local economy would be worthless to the counterparty. There are numerous examples of commodity money throughout the course of human history, but none has reached the breadth of appeal or significance to the modern financial system as gold.

Gold was recognized as a standard medium of exchange for international trade as early as 1500 BC. The first gold coins were minted in modern-day Turkey in the 6th century BC and gold as a currency eventually spread throughout Europe. By the 16th century gold had become so entrenched in the European financial system that when the Spanish Conquistadors’ treasure fleets returned from the New World, the massive amounts of gold they carried contributed to a period of inflation throughout Europe. Even the dominant reserve currency of today, the U.S. dollar, began not as fiat money but as representative money backed by gold.

Though gold is no longer used as a medium of exchange, it retains a role in foreign reserve balances. The countries with the ten largest gold holdings held a combined $1.44 trillion, at market prices, as of December 2020. This constituted 17.2 percent of their overall reserve balances. An additional $171 billion was held by the International Monetary Fund. As the Chinese economy developed, it too looked to gold as a reliable store of value. From 1980 to the end of 2000, Chinese authorities held nearly 13 million ounces. They boosted their holdings to 19 million ounces by December 2002, and to 34 million ounces in April 2009. At the end of 2020, China was the sixth largest country holder of gold (63 million ounces), behind only the United States (261 million ounces), Germany (108 million ounces), Italy (79 million ounces), France (78 million ounces), and Russia (74 million ounces).

The question is rarely asked that, if, in John Maynard Keynes’ words, gold is a “barbarous relic,” why do central banks around the world, including developing countries and the International Monetary Fund, hold well over a trillion U.S. dollars’ worth in an asset whose rate of return, including storage costs, is negative?

In my experience, there have been several cases where policymakers did contemplate selling off their gold bullion. In 1976, for example, I participated in a fascinating conversation where Secretary of the Treasury William Simon and Chairman of the Federal Reserve Board Arthur Burns met with President Gerald Ford to discuss Simon’s recommendation that the United States sell its 275 million ounces of gold and invest the proceeds in interest-earning assets. While Simon, following Milton Friedman’s view of gold at that time, delivered a detailed and quite eloquent argument that gold no longer serves any useful monetary purpose,1 Arthur Burns held the conventional view that gold was the necessary ultimate crisis backstop to the dollar and that it would be a mistake to sell our gold reserves. The two advocates were clearly unable to find common ground, and the meeting was adjourned. In the end, Ford chose to do nothing, and to this day, the U.S. gold hoard is little changed at 261 million ounces.

The next time I was confronted with the issue of whether central banks should continue to hold gold was in the mid-to-late 1990s following a decline in the price of gold to under $300 an ounce. One of the periodic meetings of the G10 governors was dedicated to the issue of the European members’ desire to pare their gold holdings. But they were aware that in competing with each other to sell, they could drive the price of gold down still further. They all agreed to an allocation arrangement of who would sell how much, and when. The United States abstained. The arrangement was renewed in 2014. In a statement accompanying the announcement, the European Central Bank stated, “Gold remains an important element of global monetary reserves.”

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Dr. Alan Greenspan

Dr. Alan Greenspan

Alan Greenspan served five terms as chairman of the Board of Governors of the Federal Reserve System from August 11, 1987, when he was first appointed by President Ronald Reagan. His last term ended on January 31, 2006. He was…
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Global Wealth Partners, Inc (“GWP”) offers wealth management services through various affiliated companies including advisory services offered by Diversify Advisory Services, LLC (“Diversify”), an SEC registered investment adviser. GWP offers additional investment services and securities through DFPG Investments, LLC., a broker/dealer, member FINRA/SIPC, and an affiliate of Diversify. GWP and Diversify are not affiliated.

https://reports.adviserinfo.sec.gov/crs/crs_326060.pdf