Fixed Income Spotlight

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Brian Rehling, CFA, Head of Global Fixed Income Strategy

• Treasury Inflation-Protected Securities (TIPS) are inflation-indexed securities that are designed to provide a real return commensurate with U.S. inflation, plus a small added return or loss.
• While TIPS can prove effective in the right situation, most retail investors may find TIPS to be a less than ideal inflation hedge.

Be cautious of using TIPS as an inflation hedge

Evidence is mounting that inflation concerns may persist longer than expected as supply chain and labor market imbalances continue to mount. With inflation expectations trending higher recently, investors looking for a solution to their inflation concerns may consider turning to Treasury inflation-protected securities (TIPS). After all, TIPS are inflation-indexed securities that are designed to provide a real return commensurate with inflation, plus a small added return or loss based on market yields. This is in contrast to a standard “nominal” Treasury security in which the coupon and final maturity value are set at issuance — with no adjustments for inflation. While TIPS may have utility for some investors’ inflation concerns, many retail investors will likely find that TIPS do not offer an effective implementable inflation solution.

5 year breakeven inflation rates

Source: Bloomberg 10/20/2021. The breakeven inflation rate represents a measure of expected inflation derived from 5-Year Treasury Constant Maturity Securities (BC_5YEAR) and 5-Year Treasury Inflation-Indexed Constant Maturity Securities (TC_5YEAR). The latest value implies what market participants expect inflation to be in the next 5 years, on average.

Do not assume

TIPS can offer a substitute for nominal Treasury securities for those investors looking to provide some purchasing power protection to a Treasury portfolio. Investors looking for a high degree of predictability can buy a new-issue TIPS, hold to maturity, and have assurance that their investment will be indexed to the Consumer Price Index (CPI). Unfortunately, the current negative real-yield environment implies a small negative return after adjusting for inflation over the life of a new TIPS security.

Some investors assume that, due to TIPS’ inflation-protection feature, these securities will provide predictable, stable returns. Importantly, however, TIPS also can generate negative returns. If TIPS are sold prior to maturity, investors are exposed to market risk. TIPS tend to be longer-duration securities (duration measures a bond’s price sensitivity to interest-rate changes). Bonds with longer duration including TIPS, tend to be more sensitive to changes in interest rates.

Important investment considerations

The knowledge of an investment professional can add value when purchasing TIPS. Investors may choose to invest in TIPS through their investment manager, through mutual funds or exchange-traded funds (ETFs), or through investment in individual TIPS holdings. When doing so, it is useful to understand the following tax considerations:

1. Purchasing TIPS directly: A buy-and-hold investor that buys TIPS directly from the U.S. Treasury and holds the security to maturity can lock in a real return equal to the TIPS yield when the investor purchased the security. Investors selling individual securities before maturity would be exposed to market risk. If TIPS are held in a taxable account, the coupon payments are taxed at the ordinary income tax rate, and the principal adjustment or index-ratio adjustment also is taxed at the ordinary income tax rate. This occurs even though the investor has not yet received payment for the principal adjustment. The principal, or index-ratio, adjustment is known as “phantom income.” As a result of their unique tax consequences, it is often beneficial to place TIPS in a tax-deferred or tax-free account.
2. Purchasing a fund holding or specializing in TIPS: If a mutual fund is purchased, it may be required to distribute the taxable income to the investor as a dividend (both coupon payment and principal changes resulting from the inflation adjustment). This can help to alleviate the “phantom income” problem, and tax reporting would be similar to that for other bond funds. Investors also have the option of reinvesting dividends in mutual funds to remain fully invested.

Our TIPS outlook for the current environment

For investors that want to incorporate inflation-protected securities such as TIPS in a portfolio, we favor investors include them as part of traditional taxable fixed-income allocation in either short-term, intermediate-term, or long-term taxable investment-grade allocations.

Wells Fargo Investment Institute currently has an unfavorable guidance position in the Treasury securities sector and a neutral position in the TIPS subsector.

Equities

Ken Johnson, CFA, Investment Strategy Analyst

• The Russell 2000 Index has underperformed the S&P 500 Index as supply constraints gave investors pause, however, we believe valuations for the equity class remain attractive.
• Medium-sized firms typically offer less risk compared to small cap firms with a tilt toward higher quality. We are neutral mid-cap equities.

Mid caps present an alternate opportunity for investors

Historically, both small- and mid-cap stocks have tended to outperform during economic recoveries, however investors appear to have turned cold toward smaller firms. The Russell 2000 Index has underperformed the S&P 500 Index by more than 5% year-to-date as of October 21, 2021, while returns of the Russell Midcap Index are on par with its larger counterparts. Concerns over increasing pricing pressures, stemming from supply constraints, has given investors pause as it pertains to smaller U.S. companies.

Small caps tend to be one of the more highly-levered equity groups. Couple this with the supply issue aforementioned, and there is potential for a persistently elevated percentage of non-earning firms. As the chart below illustrates, unlike their equity peers, small-cap equities have struggled to move meaningfully below their non-earnings peak. Despite this stubbornness, small firms still have robust earnings growth expectations and, if the 10-year Treasury yield moves higher, this could be the spark to reignite their performance. Midsize firms typically offer less risk compared to small-cap firms and benefit from a tilt toward higher quality. The Russell Midcap Index has more exposure to technology stocks and less exposure high-risk industries such as biotech and pharmaceuticals.

We continue to view small-cap equities as a favorable equity class, supported in part by attractive absolute and relative (versus S&P 500 Index) valuations. We believe Mid caps may offer another entry point for investors to participate in potential reflation rallies, while hedging some low-quality risk embedded in smaller firms. We are currently neutral mid-cap equities.

Percent of non-earning firms still near all-time highs for Russell 2000 Index

Sources: Wells Fargo Investment Institute, Bloomberg, 9/30/2021. An index is unmanaged and not available for direct investment. Past performance is not a guarantee of future results.

Real Assets

Austin Pickle, CFA, Investment Strategy Analyst

“I am different, not less.” — Temple Grandin

• U.S. oil producers have turned to DUCs (drilled but uncompleted wells) for a cost-effective way to maintain oil production. But DUC levels are declining fast.
• We believe producers will soon need to ramp up new drilling activity. Yet, we expect supply increases to be moderate and price-supportive.

Oil’s low-hanging fruit nearly gone

Over the past decade, high oil prices historically have prompted a flurry of activity and a tidal wave of additional supply as U.S. producers sought to maximize production. But nowadays, thanks to investor pressure, oil producers have committed to capital discipline which prioritizes shareholder returns and reduced leverage rather than production volumes. This paradigm shift in strategy is largely why oil production and activity levels in the U.S. have been well below pre-pandemic peaks despite oil prices being miles above breakeven costs. In the name of discipline, instead of spending money on new wells, producers have been feasting on the previously ample supply of DUCs (drilled but uncompleted wells). But it appears that the first course may soon be over.

DUCs represent the lowest-hanging fruit for oil producers. They are wells that have already been drilled but have not been readied for production. They require relatively little additional time, effort, and money to tap. In mid-2020, the inventory of DUCs reached all-time highs. Fast forward to today, and nearly all of the low-hanging fruit has been picked (see chart below). The available DUCs in major oil-producing regions like Eagle Ford and Bakken have reached data series’ lows while the Permian could reach the same milestone in roughly 6 to 9 months’ time at the current decline rate.

In other words, the low-hanging fruit is almost gone, and we believe producers will soon need to ramp up new drilling activity. Yet, we expect producer discipline to be maintained which should keep supply increases moderate and price-supportive.

DUC inventory by region

Sources: Bloomberg, U.S. Energy Information Administration, Wells Fargo Investment Institute. Monthly data: 01/31/2015 – 09/30/2021

Alternatives

Justin Lenarcic, CAIA, Senior Global Alternative Investment Strategist

• Business development companies (BDCs) continue to garner investor interest and assets, especially among those looking for incremental yield.
• Complexity and illiquidity premiums have produced an attractive spread differential between BDCs and traditional, high-yield corporate debt, despite BDCs mostly focusing on senior debt.

BDCs still offering attractive floating-rate income

With the prospect of higher interest rates, investors are becoming more sensitive to duration risk within their fixed-income portfolios. Nontraditional (or private) credit, which covers a wide spectrum of assets, is often structured with a floating as opposed to a fixed rate, significantly reducing the impact that higher interest rates have on loan prices. Lower duration risk is but one key reason that business development companies (BDCs) are seeing an influx of investment capital. Another is a broadening opportunity set, brought about by the impact of higher regulation on the ability of banks to lend to middle market companies (those with annual revenue between $10 million and $1 billion). Lastly, investors seeking income amid an environment of low or negative real rates are attracted to the spread differential that BDCs currently offer relative to corporate investment-grade and high-yield debt.

As seen in the chart below, the current yield on the Cliffwater Direct Lending Index - Senior is 7.6% as of June 30, 2021 versus a 3.8% yield-to-worst for the Bloomberg U.S. Corporate High Yield Index. In fact, the incremental yield offered by BDCs is trending higher as corporate credit spreads continue to tighten. This spread differential is not necessarily the result of BDCs owning riskier debt – as many focus on senior loans sourced through proprietary channels with covenant protection – but rather due to the complexity and illiquidity premiums inherent in private credit. As BDCs continue to evolve and mature, we anticipate growing interest and more inflows, especially among yield-hungry investors.

Attractive spread differential between BDCs and U.S. Corporate High Yield

Sources: Cliffwater, Bloomberg, Wells Fargo Investment Institute. Data as of June 30, 2021. An index is unmanaged and not available for direct investment. Yields represent past performance and fluctuate with market conditions. Current yields may be higher or lower than those quoted above. Past performance is no guarantee of future results.

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