He sees opportunities across sectors in investment-grade corporate credit, especially in consumer staples, utilities and banking/finance names that he thinks are well positioned to withstand a downturn in the economy. Penn Mutual’s unconstrained bond strategy, initiated in 2016 and rolled out in mutual fund format last year, has about half its assets in the corporate bond market (focused on the U.S.) and 30% in structured securities. The balance is in Treasurys, TIPS and taxable municipals.
The strategy’s structured security holdings include commercial mortgage-backed securities and parts of the asset-backed market, including securitized student loans. The appeal of structured securities is that they are less widely followed than parts of the corporate bond market, making it easier to identify undervalued securities, and it’s a diversifier, he says.
Penn Mutual isn’t actively invested in master limited partnerships, but it owns bonds in this space, primarily from large, diversified investment-grade MLP issuers. MLP bonds are less sensitive to commodity price fluctuations than other energy credits, says Heppenstall. MLP cash flows are contracted (related to the transportation and storage of oil and gas) and aren’t tied to oil’s underlying price.
Calming Client Nerves
Becky Gersonde, a vice president and portfolio manager at Heber Fuger Wendin, a Michigan-based independent, fee-only financial advisor and investment counsel, says the shape of the yield curve could change if there’s not enough demand to swallow up the billions of Treasury debt hitting the market to fund the swelling budget deficit. But she expects the yield curve to remain relatively flat in 2019, at around 3% straight out.
With spreads so narrow, the vast majority of her firm’s community bank clients (whom it primarily works with, besides credit union clients) have a 50% to 60% portfolio allocation to Treasurys and U.S. agency securities. Many firm clients pared their municipal holdings last year when tax law changes cut the corporate tax rate, diminishing the attractiveness of tax-free muni bonds.
Heber Fuger Wendin tends to buy individual securities for individual clients, and it has been educating them on the difference between individual bonds (in which the principal is preserved at maturity) and bond mutual funds (where the investments aren’t guaranteed). “As long as you don’t panic and sell the bond, it’s just an unrealized or paper loss,” says David Barnes, the firm’s chairman, president and CEO.
The firm is also explaining to clients that in a rising interest rate environment, funds lag individual bonds in upside performance because managers don’t churn investments fast enough to try to catch up with current rates. “If in a year or two we hit a recessionary track,” says Gersonde, and the Fed starts lowering rates, “we might be making the opposite move” by shifting from individual bonds into funds that may help preserve yield for clients.
She and Barnes are closely watching the spread between 10-year and two-year Treasurys, which they’ve found to be the best indicator of a recession. For a recession to occur quickly, says Gersonde, “you’d have to get economic data just completely falling out of bed,” with sub-2% growth and out-of-control inflation. In other words, she says, “Everything would have to turn upside down from where it is now.”