Sell-Off in Bonds Creates Potential Opportunities
The managers of Calvert Ultra-Short Income Fund and Calvert Short Duration Income Fund maintain conservative duration positioning while looking for value in corporate bonds and securitized debt.
By Cathy Roy, CFA, Chief Investment Officer, Fixed Income, Calvert Investment Management, Inc.and Steve Van Order, Fixed-Income Strategist, Calvert Investment Management, Inc.
|Steve Van Order|
Long-term interest rates have climbed steadily in the last four to six weeks as investors anticipated the end of the Federal Reserve's (Fed) purchases of Treasuries and mortgage-backed securities that are part of its quantitative easing (QE) program designed to stimulate the U.S. economy. Most areas of the bond market, including corporate bonds and securitized products, have seen price declines as investors sell their holdings amid the rising rates and declining market sentiment. Calvert's taxable bond portfolio management team has positioned the durations1 of Calvert Ultra-Short Income Fund and Calvert Short Duration Income Fund to help mitigate the negative price effects of rising interest rates relative to their passive benchmark indices. In addition, Calvert believes that the sell-off could create opportunities to add higher-quality corporate bonds and securitized debt to our portfolios at attractive prices.
The yield on the 10-year Treasury note moved from 1.66% at the beginning of May, which is approximately when fears about Fed "tapering" of its QE buying began to affect the market, to more than 2.50% in late June. The increase in rates rapidly accelerated on June 19, when Fed Chairman Ben Bernanke announced that the Fed would likely start to slow its bond purchases later in 2013 and end the QE program sometime next year if the unemployment rate continues to improve and inflation stays tame. This caused the yield on the 10-year Treasury note to jump from 2.13% on June 17 to 2.54% on June 21, which was the largest weekly increase in a decade according to Reuters.
Technical Factors Exacerbate Selling
In our view, the core of the general bond market sell-off was a clear response to the Fed chairman's statements about the upcoming end of QE, but technical market factors exacerbated the selling and caused a classic overreaction. The rapid price declines in Treasuries caused some institutional investors to have to sell other types of bonds, including corporates and asset-backed securities (ABS), to generate cash or manage the durations of their portfolios. Also, it seems to us that some investors confused the looming end of the Fed's QE with hikes in the federal funds2 rate—but the Fed has made clear that there is not a strong link between the two. In fact, short-term interest rates will probably stay anchored near zero for a few more years
Interest-Rate Duration Basics
When thinking about fixed-income investments in your own portfolio, it's important to remember that the prices of most bonds fall when interest rates rise. This is because most older bonds will pay a lower interest rate than newly issued bonds, which will need to pay higher coupon rates in order to be competitive in an environment of rising rates. As a result, the older bonds will sell for a lower price to offset their relatively low interest payments. Taking this relationship between price and yield a step further, duration measures how much the price of a bond changes in response to a change in interest rates. A general guideline about duration is that if interest rates rise one percentage point, a bond with a duration of 10 years would lose 10% of its value with all other factors being equal.
We have been maintaining a conservative duration position in both Calvert Ultra-Short Income Fund and Calvert Short Duration Income Fund (and Calvert's other taxable bond funds) since interest rates dropped to record lows after the financial crisis of 2008 and 2009. This positioning involves keeping the durations of the Funds somewhat shorter than the durations of their benchmark indices, which exposes the Funds to less of a decline in price than the benchmarks as interest rates rise.
Duration as of May 31, 2013
|Calvert Ultra-Short Income Fund||0.33 years|
|Benchmark: Barclays 9-12 Months Short Treasury Index||0.78 years|
|Calvert Short Duration Income Fund||2.50 years|
|Benchmark: Barclays 1-5 Year U.S. Credit Index||2.80 years|
Both Calvert Ultra-Short Income Fund and Calvert Short Duration Income Fund have significant allocations3 to floating-rate notes, which pay interest at a rate that changes in lockstep with a benchmark interest rate such as the three-month London interbank offered rate (LIBOR). Because their coupon rate moves up or down in tandem with short-term market rates, floating-rate notes have essentially zero interest-rate duration, which makes them an effective tool for reducing the Fund's sensitivity to changes in interest rates. Another benefit of floating-rate notes is that they currently generate more yield than short-term Treasury bills and also will pay more interest when short-term lending rates increase.
Opportunities to Add Attractively Priced Corporates and Securitized Debt
While we believe that maintaining the conservative duration positioning of the Funds will help them weather a continuing rise in interest rates better than their benchmarks, we are also trying to selectively take advantage of some attractive valuations created by the sell-off in corporate bonds and securitized debt such as ABS. Calvert's credit analysts collaborate closely with our portfolio managers to find high-quality corporates and ABS whose prices may have been beaten down to levels that don't reflect their fundamental credit quality. Unlike the volatility in late 2007 and early 2008, we don't think that the recent volatility in the bond market is a sign of an impending financial crisis. However, investors who are concerned about the volatile market environment in both equities and bonds, and want to take on only incremental interest-rate risk while having the opportunity to earn some yield, may want to consider Calvert Ultra-Short Income Fund and Calvert Short Duration Income Fund.
1. Duration measures a portfolio's sensitivity to changes in interest rates. Generally, the longer the duration, the greater the change in value in response to a given change in interest rates.
2. The federal funds rate is the benchmark rate for short-term lending between banks targeted by the Federal Reserve.
3. As of May 31, 2013, floating-rate notes accounted for 51.27% of Calvert Ultra-Short Income Fund's net assets and 16.00% of Calvert Short Duration Income Fund's net assets.
This commentary represents the opinions of its authors as of 6/27/13 and may change based on market and other conditions. The authors' opinions are not intended to forecast future events, guarantee future results, or serve as investment advice. The statistics have been obtained from sources believed to be reliable, but the accuracy and completeness of this information cannot be guaranteed. Neither Calvert Investment Management, Inc. nor its information providers are responsible for any damages or losses arising from any use of this information.
Investment in mutual funds involves risk, including possible loss of principal invested. Though each Fund strives to limit interest rate risk, changes in interest rates can adversely affect the value of an investor's securities. When interest rates rise, the value of fixed-income securities will generally fall. To the extent that a Fund holds corporate bonds and/or bank loans, it is subject to credit risk, including credit downgrades and issuer default risk. Because a significant portion of securities held by Calvert Ultra-Short Income Fund may have variable or floating interest rates, the amount of the Fund's monthly distributions to shareholders are expected to vary with fluctuations in market interest rates. Generally, when market interest rates fall, the amount of the distributions to shareholders will likewise decrease. Each Fund is non-diversified and may be more volatile than a diversified fund. There is also a risk that the Funds' portfolio management practices may not achieve the desired result.
Calvert mutual funds are underwritten and distributed by Calvert Investment Distributors, Inc., member FINRA and subsidiary of Calvert Investments, Inc.