Why it Pays to Clip Coupons    

Brain Kloss, JD, CPA
Portfolio Manager
14 May, 2018
A rising rate environment means the majority of fixed income investors’ return in 2018 is likely to come from carry or yield and not from price appreciation. Brandywine Global's Brian Kloss sees careful selection of higher yielding securities as the key for returns and protecting valuations.

Two of the biggest risks in 2018 come from the interest rate sensitivity of high quality instruments and from the impact of tightening on US high yield debt. However, a 10-year government bond is going to have much greater interest rate sensitivity than a corporate bond that matures in 2020 or 2021. While assessments from our proprietary models show U.S. high yield debt is around fair value after massive spread compression between 2009 and now.

Furthermore, it is our view that in 2018 the majority of potential return is going to come from carry or yield and not from price appreciation. So, this might not be the best time to dial down exposure to high yield. However, debt issued by higher leveraged companies is at risk from downgrades or rising defaults as rates rise. Therefore a move up in quality and taking a more conservative and defensive stance looks sensible. Security selection will be very important.

Total Return of Indices vs Standard Deviation of Indices - as of 31 December 2017

In selecting securities, we see business models that have strong management teams, significant asset protection and the ability to weather the next recession as attractive. They are even more attractive where our fundamental analysis shows the debt issued by these companies to be worth a BB credit rating, when the official rating is only a single B.

An added uplift in the high yield space is the potential for a fairly robust mergers and acquisition market. It is our belief that a lot of investment grade companies will be looking to acquire assets at below investment grade companies with good balance sheets. Steel companies, healthcare companies and energy companies are all likely targets. Here, spreads will come down for such bonds once a merger target is announced.

Another opportunity comes from a trend we have observed where lower quality credits do well in the first part of a tightening cycle. This is significant as we expect the normalisation of rates to be a very slow process; we are of the view that there will be only three rate hikes this year and not four. Furthermore, global growth is still at 2-3% and this is a conducive environment for credit instruments. While tax cuts in the US probably means that small caps and more domestic focused companies can do well. Later in cycle as you move towards the likelihood of a recession the risk grows. 

The opinions and views expressed herein are not intended to be relied upon as a prediction or forecast of actual future events or performance, or a guarantee of future results, or investment advice.

Commodities and currencies contain heightened risk that include market, political, regulatory, and natural conditions and may not be suitable for all investors.

IMPORTANT INFORMATION: All investments involve risk, including loss of principal. Past performance is no guarantee of future results. An investor cannot invest directly in an index. Unmanaged index returns do not reflect any fees, expenses or sales charges.

Equity securities are subject to price fluctuation and possible loss of principal. Fixed-income securities involve interest rate, credit, inflation and reinvestment risks; and possible loss of principal. As interest rates rise, the value of fixed income securities falls. International investments are subject to special risks including currency fluctuations, social, economic and political uncertainties, which could increase volatility. These risks are magnified in emerging markets.

The opinions and views expressed herein are not intended to be relied upon as a prediction or forecast of actual future events or performance, guarantee of future results, recommendations or advice.  Statements made in this material are not intended as buy or sell recommendations of any securities. Forward-looking statements are subject to uncertainties that could cause actual developments and results to differ materially from the expectations expressed. This information has been prepared from sources believed reliable but the accuracy and completeness of the information cannot be guaranteed. Information and opinions expressed by either Legg Mason or its affiliates are current as at the date indicated, are subject to change without notice, and do not  take into account the particular investment objectives, financial situation or needs of individual investors.

  • Important Information 

    All investments involve risk, including possible loss of principal.

    The value of investments and the income from them can go down as well as up and investors may not get back the amounts originally invested, and can be affected by changes in interest rates, in exchange rates, general market conditions, political, social and economic developments and other variable factors. Investment involves risks including but not limited to, possible delays in payments and loss of income or capital. Neither Legg Mason nor any of its affiliates guarantees any rate of return or the return of capital invested.

    Equity securities are subject to price fluctuation and possible loss of principal. Fixed-income securities involve interest rate, credit, inflation and reinvestment risks; and possible loss of principal. As interest rates rise, the value of fixed income securities falls.

    International investments are subject to special risks including currency fluctuations, social, economic and political uncertainties, which could increase volatility. These risks are magnified in emerging markets.

    Commodities and currencies contain heightened risk that include market, political, regulatory, and natural conditions and may not be suitable for all investors.

    Past performance is no guarantee of future results.

    Please note that an investor cannot invest directly in an index.

    Unmanaged index returns do not reflect any fees, expenses or sales charges.

    Important Information:

    The opinions and views expressed herein are not intended to be relied upon as a prediction or forecast of actual future events or performance, guarantee of future results, recommendations or advice. Statements made in this material are not intended as buy or sell recommendations of any securities. Forward-looking statements are subject to uncertainties that could cause actual developments and results to differ materially from the expectations expressed. This information has been prepared from sources believed reliable but the accuracy and completeness of the information cannot be guaranteed. Information and opinions expressed by either Legg Mason or its affiliates are current as at the date indicated, are subject to change without notice, and do not take into account the particular investment objectives, financial situation or needs of individual investors.

    The information in this material is confidential and proprietary and may not be used other than by the intended user. Neither Legg Mason or its affiliates or any of their officer or employee of Legg Mason accepts any liability whatsoever for any loss arising from any use of this material or its contents. This material may not be reproduced, distributed or published without prior written permission from Legg Mason. Distribution of this material may be restricted in certain jurisdictions. Any persons coming into possession of this material should seek advice for details of, and observe such restrictions (if any).

    This material may have been prepared by an advisor or entity affiliated with an entity mentioned below through common control and ownership by Legg Mason, Inc. Unless otherwise noted the "$" (dollar sign) represents U.S. Dollars.

    This material is only for distribution in those countries and to those recipients listed.

    All investors in the UK, professional clients and eligible counterparties in EU and EEA countries ex UK and Qualified Investors in Switzerland.

    Issued and approved by Legg Mason Investments (Europe) Limited, registered office 201 Bishopsgate, London EC2M 3AB. Registered in England and Wales, Company No. 1732037. Authorized and regulated by the Financial Conduct Authority. Client Services +44 (0)207 070 7444.

    All Investors in Hong Kong and Singapore:

    This material is provided by Legg Mason Asset Management Hong Kong Limited in Hong Kong and Legg Mason Asset Management Singapore Pte. Limited (Registration Number (UEN): 200007942R) in Singapore.

    This material has not been reviewed by any regulatory authority in Hong Kong or Singapore.

    Distributors and existing investors in Korea and Distributors in Taiwan:

    This material is provided by Legg Mason Asset Management Hong Kong Limited to eligible recipients in Korea and by Legg Mason Investments (Taiwan) Limited (Registration Number: (98) Jin Guan Tou Gu Xin Zi Di 001; Address: Suite E, 55F, Taipei 101 Tower, 7, Xin Yi Road, Section 5, Taipei 110, Taiwan, R.O.C.; Tel: (886) 2-8722 1666) in Taiwan. Legg Mason Investments (Taiwan) Limited operates and manages its business independently.

    This material has not been reviewed by any regulatory authority in Korea or Taiwan.

    All Investors in the Americas:

    This material is provided by Legg Mason Investor Services LLC, a U.S. registered Broker-Dealer, which includes Legg Mason Americas International. Legg Mason Investor Services, LLC, Member FINRA/SIPC, and all entities mentioned are subsidiaries of Legg Mason, Inc.

    All Investors in Australia:

    This material is issued by Legg Mason Asset Management Australia Limited (ABN 76 004 835 839, AFSL 204827) ("Legg Mason"). The contents are proprietary and confidential and intended solely for the use of Legg Mason and the clients or prospective clients to whom it has been delivered. It is not to be reproduced or distributed to any other person except to the client's professional advisers.