At the start of 2021, the yield on the 10-Year US Treasury rate was at 0.93%, but by the end of February it was near 1.5%.* Technically speaking, that means the value of a 10-Year Treasury bond would have been down by about 5% on the year. However, when you look at your February statement after you receive it this month, you’ll see your values aren’t down by 5%; they’re down by much less. That’s due to the natural “softening effect” created by credit spread compression.
The simplest way to explain it is to note that when we talk about bond values going down when interest rates go up, it must be the interest rate commensurate with that specific class of bonds. It’s also important to remember that when interest rates go down, it’s because consumers and investors are worried about the economy—which has been the case for most of the past year. On the flipside, when interest rates rise, it’s because people are growing more confident about the economy, as well as the prospect of growth and inflationary pressure, which is starting to happen now.
Why does that matter? Well, when you’re worried about the economy, you might be willing to buy a risk-free US treasury at a certain interest rate. However, in order to go from that investment to a triple-B corporate bond, you might demand a much higher rate to feel that it’s worth your while. When you’re confident about the economy, that rate difference between the government bond and the corporate bond might not need to be nearly as great for you to make the move. That’s called the risk premium, defined as the amount of extra interest an investor would require to go from a risk-free treasury to a corporate bond of a particular grade. As interest rates rise due to investor confidence, risk premiums shrink, creating a “natural softener” for actively-managed income portfolios, or the phenomenon called credit spread compression.
So, even though the yield on the 10-Year Treasury rate has gone up by over six-tenths of a percent since the start of the year, the rate on certain triple-B and double-B corporate bonds may only have gone up by about one-tenth of a percent. For you, that means even though long-term rates have skyrocketed overall , your specific allocation has helped prevent your portfolio values from dropping. The impact has been softened, thanks to credit spread compression. What’s even better is that typically when interest rates rise as rapidly as they have been, they’ll eventually level off and perhaps even drop slightly again. When that happens, income investors will have a little tailwind that could bring any drop in values back at least halfway.
When managing your portfolio at SIS, we look for one of four possible “enhancement” trades while reviewing securities and possible transactions. Income generation is our primary goal for our clients, and we consider the following four portfolio enhancements before transacting: current yield, yield to worst (minimum projected annualized total return), interest rate risk, and default risk. The intents of these transactions are categorized as follows:
- Pay Me Now – Enhancing current yield
- Pay Me Later – Enhancing yield to worst
- Cover My Assets I. – Managing interest rate risk
- Cover My Assets II. – Managing default risk
We evaluate the transactions by determining whether they meet one, two, three, or all four enhancements. A baseball analogy for this: SINGLES, DOUBLES, TRIPLES, and HOME RUNS.
There were no swaps for the month of February.
*“GameStop? Reddit? Explaining What’s Happening in the Stock Market,” NBC, Jan. 27, 2021
**“Dow Drops More Than 600 Points… Amid GameStop Trading Frenzy,” Jan. 28, 2021
***“Why GameStop Frenzy May Hurt Retirees Along with Hedge Funds,” CNBC, Feb. 1, 2021
Note: The above trades were recent block trades and do not reflect all trades done on an individual specific basis. Sound Income Strategies, LLC is a registered investment advisor. Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risk and, unless otherwise stated, are not guaranteed. Past performance is not an indication of future results. Be sure to first consult with a qualified financial advisor or tax professional about your specific financial situation before implementing any strategy discussed herein.
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