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Fixed-income comments – 3rd quarter, 2013

October 05, 2013

We’ve been sharing with investors our concerns about fixed-income investments since interest rates began their almost inevitable climb from zero. We had no foresight as to when increases would occur and still don’t, but know that we must ensure that the investments we make compensate us for the risk that rates could in fact climb. It makes no sense to us to own a bond that pays a paltry current yield as so many do today and expose ourselves to a large decline in the bond’s price should there be a material rate increase. We’re proactively managing this risk by maintaining a short duration and focusing entirely on corporate bonds. 

The benefits of owning a portfolio with a short duration in a rising rate environment is well known, but the benefits of corporate bonds are less understood. Since our inception we’ve invested solely in corporate bonds. Although we have no ability to forecast interest rates, our investment approach facilitates thorough analysis of creditworthiness and helps us identify when the market is mispricing an opportunity. In our opinion, rising rates are a positive sign for many of the businesses whose debt we own. They can signal that the U.S. government no longer believes it needs to artificially support the economy by suppressing rates. They can also mean that we’ve avoided deflation and may begin to experience economic growth, which is generally encouraging for companies, consumers and ultimately corporate credit. As corporate bond analysts, we can forget about predicting where rates are going and look instead to business fundamentals. Is the company growing? Is it stealing share from competitors? Are margins expanding? Does it generate free cash flow? These are areas in which we have expertise that lead us to businesses with creditworthiness that can improve over our holding period. Aiming to consistently outperform our benchmark via corporate bonds that have fundamentals we understand we believe is superior to trying to forecast future rates. 

Until recently, investors didn’t seem to appreciate the merits of a bond portfolio fully invested in corporate debt with less exposure to rising rates. Many simply cared only about the return. Bull markets can be characterized by investors focusing more heavily on return than risk. It takes a shock to wake up and refocus on the inherent risk in investing that’s often more important than prospective returns. Recent rate volatility highlights how “safe assets” can be quite risky. 

We define risk as permanent loss of capital. Fixed-income investments are generally less risky than equities due to their seniority in the capital structure and the stream of interest payments, but losing money is nevertheless a possibility. This is an asymmetric game generally governed by math that doesn’t apply to equity investing. Scheduled interest payments and getting your principal back at maturity set fixed-income investments apart. Their potential return, assuming no default, is known and can be measured by looking at the yield to maturity (YTM). If you hold a bond to maturity, the YTM generally represents your upside. The downside is much greater. If the bond defaults and no recovery follows, you can lose your entire investment. The downside is why fixed-income investing is asymmetric – the capped and finite upside is paired by the potential for permanent loss of capital. For this reason we always prudently judge the true downside risk in every investment that we make. This includes evaluating the assets backing the bond as well as the debtor’s ability to generate consistent cash flows that comfortably exceed the required interest payments, debt pay down and, most importantly, maintenance in their business. We analyze the downside first and then the return. Semantics maybe, but it’s key to our investment process as we first consider how much we could lose in a worst-case scenario and then try to establish the yield required to assume the risk. An investment only makes it into the portfolio if we feel that we understand the risks and are being well compensated for taking them on. Our approach to risk management has served us well and has helped us avoid situations that seemed to offer high returns at the time yet ended poorly. 

Investing always entails risk. We continue to seek to fully understand the risk involved in all of our investments and minimize its effects by singling out opportunities where we believe we have an edge. We believe that the additional return corporate bonds are paying over their government counterparts is still attractive and continue to strive to uncover businesses with improving credit, strong assets and cash flows to support our thesis.