Trustees typically allocate a portion of a trust portfolio to fixed income investments to diversify, manage risk and increase cash flow. In the past, they presumed it was easier to choose and monitor fixed income investments, as compared to equities. However, fiduciaries face additional challenges in today’s economic environment when buying, selling or retaining specific fixed income assets due to, in part, reduced credit ratings and the Federal Reserve’s monetary policies.
Traditionally, fiduciaries (and other investors) focused primarily on whether a bond or fund was taxable or non-taxable, its credit rating and yield. With recent volatility in the bond market and interest rates at historic lows (presumably through early 2014), trustees should consider: (1) sector allocation (diversification among industries), (2) sub-asset allocation (diversification among types of bonds), and (3) duration management of individual bonds or bonds within specific funds as critical for capital preservation and generation of income. Fiduciaries have the added duty to consider a trust portfolio’s time horizon, liquidity needs (mandatory or discretionary distributions), tax status (charitable or non-charitable and grantor or non-grantor), size, risk tolerance and potential competing interests of current and remainder beneficiaries. Trusts only paying out income to current beneficiaries, rather than making unitrust distributions based on total return, present additional challenges for trustees.
Fixed income specialists, and the trustees they advise, should consider balancing the following factors when monitoring existing holdings and determining which bonds or funds they should buy or sell to meet the trust’s objectives and prudent investor standards:
• Reliability of the investment’s credit rating;
• Taxable or non-taxable nature;
• Yields in a market with a narrow range of low interest rates, but with volatility within the range;
• Reliable cash flow;
• Risk-adjusted returns—whether higher yields justify the increased risk;
• Diversification among sectors, as with equities (for example, energy, financials, utilities and consumer);
• Diversification among sub-asset classes, such as investment-grade bonds, high-yield bonds, agency mortgage-backed securities, general obligation municipal bonds or essential service revenue municipal bonds;
• Correlation among the various types of bonds or funds to mitigate risk—same strategic and tactical mindset as managing equities; and
• Duration of individual bonds or bonds within funds, knowing interest rates will increase—to what extent and when, may likely affect the value of a portfolio’s holdings.
One reason for balancing these factors is that for the near future, several international and domestic issues remain unresolved. The U.S. Treasury market in fourth quarter 2011 and throughout first quarter 2012 has been strongly influenced by a flight to risk-averse quality investments caused by the European debt contagion issue. The Federal Reserve’s accommodative credit policies have forced advisors in the fixed and equity markets to acknowledge low domestic interest rates will continue while the nation’s economy rebuilds, and the housing market continues to struggle. A third round of quantitative easing—continued low interest rates by the Federal Reserve—isn’t officially off the table should the economy stall. Not as dramatic, but certainly as important, are the presidential election rhetoric and potential ramifications of a revised tax code that will attempt to reduce the national deficit. Consequently, interest rates and total returns remain low. For example, in mid-April, the 10-year Treasury traded in a range of 2 percent to 2.4 percent. However, coming off of such low yields at the end of 2011, longer term Treasury returns are negative. From the beginning of the year to mid-April, the longer term Treasury market produced a negative 0.23 percent in total return, primarily influenced by a 3.26 percent decline in the Treasury 20-year plus sector.1
The recent negative returns of U.S. Treasuries further reinforce the need for fiduciaries to consider diversifying portfolio risk across multiple sub-assets, such as investment-grade corporate bonds, municipal bonds and mortgage-backed securities. These sub-assets have positive year-to-date returns and, in some cases, approach equity market returns. Overall, the investment-grade corporate bond market has provided diversification and a reliable source of positive return and consistent taxable income. In mid-April, the investment-grade corporate bond market realized a year-to-date positive return of 3.02 percent, with the financial sector as the principal contributor. From the beginning of the year to mid-April, high-yield corporate bonds produced returns in excess of 5 percent.2 This sub-asset class is a compelling alternative for portfolios striving to maintain a balanced income stream versus equity dividend income. A defined allocation to high-yield corporate debt can be a constructive addition within an investor’s fixed income strategic allocation.
Fixed income investors often overlook another fixed income sub-asset, agency mortgage-backed securities. These securities are comprised of pools of residential mortgages, which have unique features. They can provide a higher yield and liquidity without sacrificing credit quality. Many investors don’t know that the agency mortgage-backed securities market is a very large fixed income sub-asset with over $5 trillion in market value. These securities make up over 30 percent of the Barclays Aggregate Index, second only to U.S. Treasuries.3
Some trusts can benefit from the potential tax-free advantage of municipal bonds. Certain trusts, such as non-grantor trusts with multiple income beneficiaries (living in different states or having disparate income levels), charitable remainder trusts and non-grantor charitable lead trusts would most likely not benefit due to lower yields with nominal or no tax benefit. For those trusts (or their beneficiaries) that may benefit from investing in municipal bonds, these bonds have performed relatively well, considering they’re exempt from federal income tax and certain state and local tax. The overall performance from the beginning of the year to mid-April of a positive 2.39 percent has been indicative of the strong demand for these tax-advantaged investments.4 However, the traditional demand for General Obligation bonds (those backed by the full faith and credit of the issuing municipality’s ability to levy and raise taxes), has been supplanted by a growing awareness that better value might be found in essential service revenue bonds. These bonds are state-specific agencies and authorities that have the legal ability to issue debt for purposes such as infrastructure repair, educational and health facilities. The debt is serviced by adjusting the fees, tolls, lease payments and any other allowable ancillary charges.
Other factors contribute to municipal bond outperformance relative to Treasuries. Last year, high demand and the lowest dollar amount of new issuance of tax-exempt bonds in a decade added to the overall strength of that market. It’s been suggested that there could be as much as a 30 percent increase in new issuance this year. Investor demand hasn’t decreased, even when an increased supply contributes to temporary volatility. Municipalities continue to face budgetary constraints, as allocated federal monies in the form of Medicare payments, educational grants and housing assistance will surely be reviewed and trimmed. Certain investors, especially fiduciaries, remain concerned about agencies that rate municipal debt. Also, there has and probably will continue to be headline risk of certain municipal borrowers contemplating bankruptcy. Even though the amount of municipal debt involved is de minimis versus the overall outstanding municipal debt, these factors reinforce the need for proper credit monitoring.
Fiduciaries now contend with a layer of complexity when investing in fixed income not necessarily seen in the past. The traditional fixed income asset allocation is hard pressed to sustain any reasonable level of total return in today’s market. Risk-adjusted returns derived from prudent management and a diversified asset allocation strategy should be a successful recipe to maintain positive returns during this prolonged period of low interest rates. Returns tend to be derived from income rather than appreciation. Investors can obtain exaggerated yields far greater than what can be expected in this current market, either by accepting lower investment quality or by extending the overall duration of the portfolio. While those options may be acceptable in individual investor’s portfolios, they may well be contrary to fiduciary prudent investor standards. However, a modest allocation to higher yielding fixed income investments may enable tactically minded portfolio managers to take advantage of interesting opportunities when they present themselves. The risks involved in today’s fixed income markets, whether they’re based on monetary policy dictates, the political mandates of Congressional action or the unsettling landscape of global geo-political uncertainty, demand a comprehensive approach to address and manage the volatility inherent in fixed income investing.
1. Barclays Index, as of close of business on April 13, 2012.
Diversification does not ensure a profit or guarantee against loss. Investing in fixed-income securities may involve certain risks, including the credit quality of individual issuers, possible prepayments, market or economic developments and yields and share price fluctuations due to changes in interest rates. Tax-exempt investing offers current tax-exempt income, but it also involves special risks. Single-state municipal bonds pose additional risks due to limited geographical diversification. Interest income from certain tax-exempt bonds may be subject to certain state and local taxes and, if applicable, the alternative minimum tax. Any capital gains distributed are taxable to the investor. Treasury bills are less volatile than longer term fixed-income securities and are guaranteed as to timely payment of principal and interest by the U.S. Government. For investments in ABS, MBS, and CMOs generally, when interest rates decline, prepayments accelerate beyond the initial pricing assumptions, which could cause the average life and expected maturity of the securities to shorten. Conversely, when interest rates rise, prepayments slow down beyond the initial pricing assumptions, which could cause the average life and expected maturity of the securities to extend and the market value to decline.
U.S. Trust operates through Bank of America, N.A., and other subsidiaries of Bank of America Corporation. Bank of America, N.A. and U.S. Trust Company of Delaware (collectively the “Bank”) do not serve in a fiduciary capacity with respect to all products or services. Fiduciary standards or fiduciary duties do not apply, for example, when the Bank is offering or providing credit solutions, banking, custody or brokerage products/services or referrals to other affiliates of the Bank.
—Bank of America, N.A., Member FDIC