Parnassus Digest - January 2014
The Evolution of the Parnassus Fixed-Income Fund and Opportunities for 2014
Since Portfolio Manager Samantha Palm joined Parnassus Investments seven months ago, the fixed-income market has endured dramatic changes: expected returns, risk profiles and expectations for the future are all markedly different from the spring. While change isn’t always easy, it can be managed with the right tools and a keen eye on the future. In this Parnassus Digest, Samantha will discuss changes in the fixed-income market and in the Parnassus Fixed-Income Fund, as well as opportunities in this market for the future.
The impact of rising interest rates is at the forefront of investors’ minds today. While rising interest rates lead to lower bond prices, each asset class responds differently under these conditions. As a result, a portfolio’s composition and characteristics can lead to markedly different performance relative to its peers.
First, and most importantly, when interest rates rise, available yields rise as well. This means that there is a reinvestment opportunity – or that funds received from maturing bonds can be reinvested at higher rates of return. Managers with a meaningful percentage of assets maturing in the next 24 months should benefit from reinvesting funds at higher yields for the same (or perhaps lower) credit risk. This is a boon for investors and helps temper the losses resulting from declining bond prices.
Second, not all investments experience the same degree of losses in a rising rate environment. In fact, during the Federal Reserve’s last tightening cycle between 2004 and 2006, certain bond classes still had positive returns. According to a research paper published by Morgan Stanley last summer, convertible bonds, asset-backed securities, short-dated bonds, corporate credits and mortgage-backed securities all had positive returns during periods of tightening monetary policy.1 This means that opportunities continue to exist for investors to realize increased income, and mitigate losses, while yields rise.
One particularly important attribute of the Parnassus Fixed-Income Fund is its relatively conservative composition. Many other fixed-income funds, even those labeled “investment-grade,” can have relatively high risk profiles as measured by beta. Beta is a measure of a portfolio’s volatility relative to its benchmark. Portfolios with a beta of greater than 1 are more volatile than the index, whereas those with a beta of less than 1 are less volatile. As certain funds chased higher-yielding investments over the past four years, features like leverage and derivatives were used more heavily, thus increasing beta. When the market experienced losses last summer due to rapidly rising Treasury yields, the 10 largest bond funds with publically available data lost 6.51%, likely due to these risk-taking features, whereas the benchmark only lost 3.81%.2 As a result, I believe the conservative model used by the Parnassus Fixed-Income Fund is a benefit to investors looking to establish a sturdy foundation in their portfolios.
For a deeper dive into asset allocation and the role of fixed-income, please reference our recent white paper.3
Since I joined the firm on May 1, 2013 a number of important changes have been made to the portfolio. First, Treasury bonds have been deemphasized. The reason for this change is simple: Treasury bonds tend to underperform other asset classes in nearly all market conditions, except during times of fear. While rapid economic growth has remained elusive, all signs point to continued and steady growth. This means that other fixed-income asset classes should perform better, even if the Federal Reserve remains very accommodative. As an example, corporate bonds benefit as companies become healthier, generate more cash and accrue more earnings. Commercial mortgages also benefit in this environment, since those same businesses are then less likely to miss mortgage payments. In short, a strengthening economy diminishes the need to have a high proportion of Treasuries in the portfolio.
Second, the allocation of corporate debt increased. Corporate balance sheets are historically robust and, as the economy continues to recover, I expect corporations to continue to perform well. Given this, I believe the relative credit risk of high-quality corporations should decline and these credits are likely to perform well. As an example, FedEx Corporation, Motorola Solutions, Inc., and Nordstrom, Inc. have been added to the portfolio, based on the strength of their core businesses, their competitive advantages, their opportunities for margin improvement and the relative value of their bonds.4
Third, the allocation to mortgage debt increased. The Fund’s mortgage exposure can be classified into two buckets: Commercial Mortgage-Backed Securities (CMBS) and U.S. Mortgage-Backed Securities (U.S. MBS). There are several differences between the two asset types. CMBS are pools of mortgages on commercial properties and can include loans for office buildings, retail centers, multi-family housing and hotels. On the other hand, U.S. MBS pools only include loans on residential properties and, because most have been issued by a government agency (like Freddie Mac or Fannie Mae), the loans conform to certain standards.
The pre-payment profiles for the two mortgage-backed securities are also different and, therefore, lend different characteristics to the portfolio. CMBS behave similarly to corporate credits because they have more predictable pre-payment periods. Borrowers are discouraged from pre-paying the mortgage by additional fees, so for a well-performing CMBS credit, it’s more likely that the security will be repaid on schedule. However, CMBS are economically sensitive to the recovery of the real estate market: as tenants’ financial profiles strengthen, the credit profile of CMBS improves, allowing the asset to perform well.
For U.S. MBS, the repayment of the principal is sensitive to both interest rates and economic growth. One important difference is that homeowners can pre-pay mortgages or refinance at any time. In times of economic growth, homeowners are less likely to refinance their home mortgage if interest rates rise (which leads to slower repayment of the bond), but are more likely to move into a bigger house or to a better neighborhood if their income rises (which leads to faster repayment of the bond). This means that an investor must carefully balance the composition of residential mortgages in a portfolio to optimize the return in a rising rate environment.
Finally, convertible bonds are being selectively added to the portfolio.1 Convertible bonds share properties of both debt and equity. Because the bond pays a coupon (or an interest payment) and has a final maturity date, at which point it is expected to be repaid, it can act very similarly to a traditional bond. However, because the bond can convert to equity if certain conditions are met (usually this means the stock price goes up and exceeds a target value over a period of time), holders of convertible notes also benefit if the equity appreciates. For that reason, convertible bonds can be a meaningful way to supplement fixed-income returns. Companies that issue convertibles generally fall into two categories: early-stage, high growth companies, and companies working through a major business model or financial model change. By leveraging the expertise and market knowledge of the Parnassus Investments equity research team, I can focus on companies with a defensible market position and disruptive products. By doing so, the goal is to add convertible bonds that have a lower risk profile and more upside potential.
It’s been a bumpy road for the economy since the recession ended in 2009, but I remain encouraged by the most recent economic data. In fact, economic growth seems to be picking up momentum. It’s likely that 2014 will continue to be turbulent as the Federal Reserve’s Quantitative Easing program is removed, but a return to more normal policies and higher rates of growth is good for the economy. Because I expect interest rates to rise moderately through the next year, the Fund’s duration is shorter than the benchmark’s. As a reminder, duration is a measure of interest rate sensitivity and indicates how much, in percentage terms, a bond price will move for a 1% change in interest rates. A fund with a shorter duration has relatively less sensitivity to rising interest rates.
While the Fund’s holdings will continue to evolve according to the opportunities listed above, the focus and objective will always be principal preservation with risk-balanced income generation.
Thank you for your trust and investment.
1Morgan Stanley. “Fixed Income in a Rising Rate Environment: What Are the Alternatives?” 2013.
2Source of data is Bloomberg L.P., calculations performed by Parnassus Investments.
4As of December 31, 2013 FedEx Corporation represented 1.5% of the Parnassus Fixed-Income Fund, Motorola Solutions, Inc. represented 1.4% of the Parnassus Fixed-Income Fund and Nordstrom, Inc. represented 0.4% of the Parnassus Fixed-Income Fund
5Parnassus Investments’ data as of 12/31/2013.
The views expressed in this Parnassus Digest are subject to change at any time in response to changing circumstances in the markets and are not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally, or the Parnassus Funds. Investment return and principal value will fluctuate, so that an investor’s shares, when redeemed, may be worth more or less than their original cost. Investments in fixed-income securities are subject to interest rate risk, credit risk and market risk, each of which could have a negative impact on the value of these securities.
The Parnassus Funds are underwritten and distributed by Parnassus Funds Distributor, a subsidiary of Parnassus Investments and FINRA member.
Before investing, an investor should carefully consider the investment objectives, risks, charges and expenses of the Funds and should carefully read the prospectus or summary prospectus, which contains this information. A prospectus or summary prospectus can be obtained on the website, www.parnassus.com, or by calling (800) 999-3505.