February 2021 - Interest Rate Risk Enters the Equation

In sections below, Mike and I provide you with our perspective on what we believe is happening and why. First, however, what do rising interest rates mean for your RCM managed portfolio?

Rising Interest Rates and Your RCM Portfolio

Roosevelt Capital Management takes a four-pronged approach to fixed income investing in today’s environment:

1. Short Duration            3. Corporate bonds
2. High Yield                   4. Separately managed accounts

In a rising interest rate environment, being short duration becomes an increasingly important variable in the investment process. The duration of RCM’s corporate composite is just under 2 years. As a result, a change in rates, even the extreme changes we have seen recently, do not meaningfully impact the mark to market value of the portfolios we manage.

The more interest rates rise, the more significant mark to market losses become. RCM’s short duration strategy addresses the impacts of interest rate risk by largely avoiding it.

There is no free lunch of course. While the interest rate risk of the Treasury is much higher than the high yield bonds in RCM’s corporate composite, high yield bonds have significantly higher default risk. We will discuss how RCM manages default risk in a future letter.

*Based on 0.25% increase in interest rates

One final note on the current interest rate environment and your portfolio. While it seems counter-intuitive, RCM clients’ portfolios actually benefit from a rising rate environment because short duration portfolios generate significant cash flow via redeemed principle. This relatively short redemption cycle allows us to re-invest client capital at higher expected returns without having to turn market-to-market losses into realized losses in order to free up capital to re-invest.

What is Happening with Interest Rates and Why

The selloff in US Treasuries continued this past week. Through last Thursday’s recent peak in yields, the 5-year Treasury is up 0.63%, the 10-year 1.01% and the 30-year 1.04% from their August lows. These are very significant moves. Rates are now approaching pre-pandemic levels.

What is not directly driving rates higher - the Fed. Federal Reserve Chair Jerome Powell stated this past week that this is no time to be thinking about monetary tightening or worrying about inflation and that with 10 million people out of work policy makers should be focused on unemployment.

What is pushing rates higher is the singular concern that the economy will overheat leading to inflation. The reason for this fear is significant economic growth brought on by:

1. Vaccines and herd immunity heralding the end of Covid’s most significant economic impacts,
2. Easy monetary policy including quantitative easing and Powell’s dismissal of inflation risk,
3. Significant past fiscal stimulus to combat GDP decline resulting from the pandemic,
4. The latest $1.9 trillion fiscal spending bill expected to be signed imminently, and
5. Technical factors such as “convexity hedging”.

Misconceptions about the Safety of Treasuries & Interest Rate Risk

It is important not to lose sight of the fact that investors in US Treasuries have taken a significant mark to market hit since August. Put more bluntly – they have lost money.

As the chart to the left shows, since early August the increase in rates has resulted in:

• ~3% loss to 5-year Treasury holders,
• ~8% loss to 10-year holders, and

• ~20% loss to 30-year holders.

How can that be when Treasuries are supposed to be “safe”? As we briefly discussed in our January 2021 letter, the two primary risks that bondholders face are default risk and interest risk. While Treasuries are deemed by many to have no default risk because they are backed by the full faith and credit of the United States government, they do have interest rate risk. The 30-year Treasury has a duration of approximately 20 years, meaning that a rate increase of 1% would result in a loss of 20%. Over the last 20 years the 30-year Treasury has averaged a yield of 3.78%; implying a peak to trough loss of nearly 50% if rates were to trade there.

What Rising Rates Means for Equities

The rise in rates between August 2020 and early February 2021 buoyed equity holder confidence about future growth and stocks rallied.   However, since mid-February, concerns about overheating inflation brought on by the acceleration of interest rate increases spooked the markets and the S&P 500 fell 3.2% and the NASDAQ 6.4%. Benjamin Graham famously said, “in the short run, the market is a voting machine but in the long run, it is a weighing machine.” We have no view of equities over the short term, but longer-term rising yields present three distinct and separate headwinds for stocks.

• Stocks are valued using discounted cash flow models. Rising rates mean that the discount rate, or denominator used in those models, is higher, reducing the net present value of a company’s future cash flow.
• Again, looking through the lens of a discounted cash flow model, rising rates also means that borrowing costs will be higher thereby reducing cash flow, or the numerator used in the model, once more reducing the net present value of a company’s future cash flow.
• Higher rates provide competition for capital that would otherwise flow into equities.

Conclusion

Inflation has not been a risk that the markets have had to manage for a long time but that may be changing. Interest rate risk is real and duration matters. RCM manages interest rate risk by effectively avoiding it.

Please reach out to us with questions and comments. Thank you for trusting RCM with your capital. It is a privilege for us to serve you.

David and Mike

Disclaimer

Roosevelt Capital Management LLC is a registered investment adviser. Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risk and are not guaranteed. Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein.

Past performance is not indicative of future performance. Principal value and investment return will fluctuate. No guarantees or assurances that the target returns will be achieved, or objectives will be met are implied. Future returns may differ significantly from past returns due to many different factors. Investments involve risk and the possibility of loss of principal.

The performance and characteristics information contained herein is for accounts solely managed by David Roosevelt, Managing Member of Roosevelt Capital Management LLC. Investment performance and characteristics through September 2019 are for Roosevelt Investments accounts managed by David Roosevelt. Investment performance and characteristics for October 2019 and thereafter are for Roosevelt Capital Management accounts managed by David Roosevelt. The performance information has been certified by ACA Compliance through December 31, 2018 and is available upon request. The values and performance information contained herein do not reflect management fees. While all the values used in this report were obtained from sources believed to be reliable, all calculations that underly numbers shown in this report believed to be accurate, and all assumptions made in this report believed to be reasonable, Roosevelt Capital Management LLC neither represents nor warrants the reports, values, calculations or assumptions and encourages each prospective investor to conduct their own review of the reports, values, calculations and assumptions.