FPA New Income Fund commentary for the month of November 2016.
With U.S. Treasury yields, once again, near record lows we felt it prudent to examine key aspects of the bond market and highlight how we have positioned FPA New Income, Inc. (the “Fund”) in light of this. The 10-year Treasury note’s yield has fallen from 3% in 2014 to less than 1.4% earlier this year. We have long-discussed the risks these low rates create for the bond market. As a result “core” bond funds – those funds that have similar yield and duration1 characteristics to the Bloomberg Barclays U.S. Aggregate Bond Index (the “Index”) – find themselves in a particularly precarious position.
Investors might utilize core bond funds to achieve one or both of the following roles in a portfolio:
- Add a less volatile source of income and return to a portfolio.
- Reduce overall portfolio volatility through the use of an asset class that does not have a strong positive correlation to equities or other equity like investments.
FPA New Income Fund
In light of current bond market conditions, below we examine our concerns with the ability of core bond funds to fulfill these roles. We also introduce FPA New Income as a potentially attractive investment alternative for meeting these two objectives.
Currently, investors in core bond funds are receiving historically low yields while also taking on historically high levels of interest rate risk. The chart below shows the ratio of yield per year of duration which measures the Index’s ability to withstand rising interest rates and credit spreads. A lower ratio means that the Index is more exposed to losses if interest rates and/or credit spreads were to rise.
Over the past several years, the Index has generated attractive returns. However, these returns have resulted mostly from price appreciation (yields falling) rather than from income. 2012 was the most recent time that interest rates or yields neared today’s levels. Subsequently, in 2013, yields began to rise, resulting in losses, large drawdowns, and higher volatility for the Index. The table below compares the performance of the Index from July 2012 when 10-Year Treasury rates were at the lowest point since the inception of QE3 through 12/31/13, which marked the post-QE high in rates. Also shown is the performance of FPA New Income over this time period:
During those 15 months, the Index experienced a loss that erased more than three years of income. Should another retracement occur today, it would not be a surprise to see the Index post similar losses again. Thus, we question whether the Index is well suited today as a low volatility source of income and return. In contrast, during the 2012-2013 period, FPA New Income produced a positive return with a smaller drawdown and much lower volatility.
Indeed, FPA New Income may be in an even better position today to deliver attractive absolute and risk-adjusted returns than it was at the beginning of 2013. As of September 30, 2016, the Fund had a 32% greater yield-to-worst than the Index while taking on just 24% of the interest rate risk. These advantages over the Index are at or near three-year highs.
Notwithstanding the foregoing, some investors may own core bond funds because of a view that the U.S. may follow Japan and Europe into zero or negative yield territory. It is possible that bond yields could decline even further if, for example, the economy goes into a recession or deflation fears reemerge. However, unless one assigns a high probability to that outcome, core bond funds, in our opinion, now look more like deflation protection with a negative skew5 than an actual investment.
Alternatively, some investors may own core funds not because of their investment merit but because of their attribute of being less correlated to and less volatile than other investments. For example, core bond funds have typically had a negative correlation to major equity markets during major selloffs. However, the negative correlation feature of the Index has predictably decreased along with the Index’s yield. While we do not manage FPA New Income for short-term performance, its longer-term performance has exhibited a low or negative correlation to the S&P 500 Index, similar to the Bloomberg Barclays U.S. Aggregate Bond Index.
In conclusion, upon analyzing the investment characteristics of core bond funds, we believe it is prudent for investors to consider reducing exposure to interest rate risk within the context of their “core” bond holdings. In this environment, unless investors are trying to protect against a tail event, FPA New Income may well serve as an attractive “core” in the portfolio, as it has historically offered more yield than the Index with significantly less interest rate risk while serving as effective portfolio ballast.
Thomas H. Atteberry
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