Now that interest rates are rising, you may have seen headlines screaming “sell bonds” because bond prices fall when interest rates climb.
But Jeff Klingelhofer and Christian Hoffmann, co-managers of Thornburg Strategic Income Fund
argue that rising interest rates are good for bond investors — especially when a fund manager employs an active style that “can get into the weeds” and identify attractive income-producing securities.
Klingelhofer and Hoffmann explained in a recent interview how they analyze bonds and other income-producing securities, and discussed opportunities and risks they see now:
MarketWatch: It’s been a long time since investors have faced a rising-rate environment. What do you think of warnings to investors to sell bonds or bond funds now?
Klingelhofer: Rising interest rates are good for shareholders who are trying to generate more income. Not immediately, but over time. One of the reasons to have active management is to have the active view. We take risks in the right quantities and the right times.
Pure interest rate exposure is not the only lever. As interest rates have risen, we have been able to avoid some of the capital losses associated with them and to reinvest at higher rates to drive higher income for our shareholders.
In 2017, credit valuations were extremely tight. In that environment, we are happy to take risk when we are well compensated, but when we are not well compensated, we take less of it. So in 2017 we were de-risking the portfolio.
Now in 2018 as rates have risen and credit spreads [between high-yield bonds and government bonds] have widened, we are in a position to put more capital to work for our shareholders. This is the countercyclical thinking.
Hoffman: People have been worried about rising rates for almost a decade. If you have stayed on the sidelines you have missed out on significant rewards. Any study of modern portfolio theory suggests credit has a place in the vast majority of, if not all, portfolios.
MarketWatch: Can you give an examples of a special opportunity you have found running the fund, or special strategies that have enabled shareholders to enjoy higher yields, capital gains, or both?
Klingelhofer: My general view is the U.S. broadly is the bright spot of the global economy. The U.S. consumer is strong, employment is picking up. So I might look toward anything tied to U.S. discretionary.
If I look at the airline sector for example, I can buy an American Airlines
corporate unsecured bond or I can buy an EETC [enhanced equipment trust certificate].
If American Airlines wants to purchase airplanes, they issue EETCs and the trust holds the aircraft. AA makes lease payments to pay interest to the bondholders and pay down the debt. In the event of default of American Airlines, you are a secured note holder of the company. To the extent that the proceeds on the sale of the aircraft are insufficient to repay the bondholders, you become an unsecured creditor through bankruptcy proceedings.Then you are exactly equal to the unsecured corporate holders, but you have already recovered something. You always and everywhere are better off in a bankruptcy holding that paper. You have the aircraft and if those are not enough, you then go to [the company].
MarketWatch: What are some painful lessons you have learned as bond managers?
Klingelhofer: One big thing is managing through a cycle. We are paid to take an active view, which is often countercyclical to the market’s current view. That can work against you for a while. One of the most challenging things for portfolio managers to learn is to have discipline and continually reassess the thesis. Another is to potentially add to your position as your conviction increases or the valuation becomes more attractive.
Hoffman: As we study credit covenants over time and see covenant quality deteriorating, we are taking a firmer view on the character of management and the incentives of the company, as opposed to relying on covenants. [A covenant is a set of requirements a borrower agrees to comply with. This can include providing information to the lender on an ongoing basis and maintaining financial strength according to what is agreed to in the covenant.]
You had better protection in the past. Private equity firms have found ways to create value by inserting loopholes and provisions into covenants or taking away covenants to allow them optionality in the future, which hurts recoveries for credit investors.
MarketWatch: What are you doing now to manage this?
Hoffman: We’re still studying the covenants, but our weighting on the character of management has increased significantly. You look at track records. A public company is generally going to be more conservative than a private equity firm. [We prefer] a management team that has managed through cycles. You knew a private equity manager will try to extract as much value as possible through the balance sheet.
MarketWatch: Can you give an example of problems with covenants?
Hoffman: J. Crew was a poster child for this. [The clothing company was taken private in 2011.] In late 2016, J. Crew transferred certain intellectual property to an unrestricted subsidiary using the permitted investments basket in its credit agreement in a series of transactions. This meant that secured lenders no longer had liens on those assets. Along with deteriorating performance and excessive leverage, what many investors purchased as a perceived “safer” investment turned out to be anything but that.
We would not be surprised to see similarly lender unfriendly transactions take place in the future, using similar and other loopholes
MarketWatch: Are you equipped to detect these loopholes?
Hoffman: We study the incentives and are evaluating character to avoid those situations.
Klingelhofer: You are never going to be able to quantify every risk. But our team excels at having a very good understanding of risk and reward across sectors of fixed income and being able to allocate where the risk versus reward [balance] is better.
Morningstar rates the Thornburg Strategic Income Fund’s class I (institutional) shares four stars out of five. The class I shares charge an expense ratio of 0.69% of assets and are mainly distributed through investment advisers. The fund’s class I shares recently sported a 30-day yield of 3.34%, compared to a yield of 2.84% for 10-year U.S. Treasury notes
Here’s how the shares performed through March 31, after expenses, against the fund’s two benchmarks and their Morningstar category:
|Total return – 2018||Average return – 3 years||Average return 5 years||Average return – 10 years|
|Thornburg Strategic Income Fund – Class I
|Bloomberg Barclays U.S. Universal Index||-1.4%||1.8%||2.2%||4.0%|
|Morningstar Multisector Bond category||-0.5%||3.1%||2.9%||6.1%|
|Sources: Thornburg Investment Management, Morningstar Direct|
The blended index is 80% the Bloomberg Barclays U.S. Aggregate Index and 20% the MSCI World Index, which is an equity index. The blended index is meant to incorporate the additional risk the fund takes by investing across asset classes. That being said, the Thornburg fund was 82% invested in bonds as of Feb. 28, with 12% in cash and the rest in other asset classes, including preferred stocks, which made up only about 2% of the portfolio. About 92% of the portfolio was invested in the U.S., Canada and Great Britain, with no other country making up more than 1%.