INSIGHTS

On May 16, 2016

AAM Viewpoints - What happens if the Fed Raises Rates Again?

In December 2015 the Federal Open Market Committee (FOMC) moved to begin to tighten monetary policy by hiking rates for the first time in 10 years coming exactly seven years to the day after the initiation of the FOMC zero-rate policy. At their last meeting, in April of 2016, the Federal Open Market Committee held the Fed Funds rate steady at 0.25%-0.50% in an effort to maintain consistency with their mandate of maximum employment and price stability. Meeting Minutes reflect committee expectations that economic activity will continue to expand at a moderate pace and labor market indicators will continue to strengthen. Continued expansion and improving labor markets were offset by concerns over pockets of domestic weakness and global economic conditions. Six months removed from the hike in December 2015, the Committee now sees economic conditions evolving in a manner that will warrant only gradual increases in the Fed Funds rate over the next 12 – 18 months. We started 2016 with expectations of up to four rate hikes, with a 93.3% probability of at least one by the close of the year. Since the start of the year expectations for the number of potential hikes in 2016 has fallen to two the probability of at least one by year end has dropped from 93.3% to 51.8%, based on Bloomberg data.

What happens if the Fed raises rates?

When the Fed raise short-term rates it impacts the short end of the yield curve while other supply and demand oriented fundamentals impact the longer end. This divergence is reflected in the steepness of the yield curve. As expectations for future growth increase the yield curve steepens and as expectations surrounding growth fall the yield curve flattens. One common point of reference is the difference (measured in basis points or “bps” for short) between the 30-year Treasury yield and the 5-year Treasury yield. Currently the spread stands at 137bps, which is up from 109bps on 12/31/2014 (see chart below). We view this steepening as a positive and are constructive on the potential for growth moving forward. As the Fed continues to tighten, the immediate impact may be increased volatility, but if they remain transparent we should have a good idea of when to expect the next rate hike. Improving growth prospects, the potential for volatility in regards to future rate trajectory and burgeoning signs of inflation all lead us to position fixed income portfolios in a defensive nature.

Source: The Department of the Treasury

How do you minimize the impact of higher rates?

Duration is the key interest rate metric – in regards to rate levels – that should be considered when constructing fixed income portfolios. While duration is measured in years it is really a measure of interest rate risk and approximates the sensitivity of single security or portfolio of securities to a given move in interest rates. For every unit of duration a security or portfolio will lose/gain approximately 1% for every 100bps movement up/down in rates. For example, a bond or portfolio of bonds with a duration of five years will lose approximately 5% if interest rates move up 100 bps or conversely gain approximately 5% with a 100 bps movement down in rates. Duration should be the first consideration when structuring fixed income portfolios and should be positioned relative to a client’s given risk tolerance. Investors should also consider high coupon and/or callable bonds to help reduce interest rate risk. Duration is a function of cash flows and the higher the cash flows the shorter the duration. Higher coupon bonds typically have a lower duration than smaller coupon bonds all else being equal. Callable bonds typically have a duration in line with the call features as opposed to the final maturity and, as such, callable bonds typically have a shorter duration than their non-callable counterparts. Shorter duration bonds have historically produced better returns in rising rate environments than longer duration holdings.

For example, if an investor had purchased the 1.625% U.S. Treasury Note of 2026 on 02/11/2016 when the 10-year Treasury touched the 2016 low of 1.66%, the return to date would have been roughly -1.2% with the move up in rates from 1.66% to the current level of approximately 1.74%. Under this scenario, you would have given up almost a full year of income on a modest 10bps movement up in interest rates. The loss of over 1% on an interest rate move of only 10bps reflects the longer term nature of the securities duration which is over nine years. The longer the duration, the more principal volatility one should expect as interest rates increase.

How do you position income-oriented portfolios in anticipation of a rising rate environment?

Income investors will likely need to maintain a healthy allocation to fixed income assets even as interest rates move up and/or down. With that being said, with proper diversification across asset classes, sectors and credit qualities one can help to insulate portfolios from the effect of a potential move up in rates in the future. The chart below summarizes returns by fixed income asset class since 2014.

Source: Barclays. Past performance is not indicative of future results.

While 2015 was a challenging year for most income-producing assets, save municipals, opportunities did exist and volatility was reduced with proper diversification across asset classes, sectors, and credit qualities. Sector diversification becomes more important as rates rise as certain sectors such as financials can benefit from increased rates. In addition, where risk tolerance allows, one might consider adding some credit risk exposure. Credit spreads typically narrow in a rising rate environment where supported by strong economic fundamentals and could help offset rate volatility. Finally, investors with the appropriate risk tolerance could consider an allocation to alternative income producing assets such as Business Development Companies (BDCs), Real Estate Investment Trusts (REITs), and Master Limited Partnerships (MLPs). These assets have the potential to provide higher levels of income than most fixed income, have historically performed better than bonds in rising rate environments and carry low to negative correlation with bond returns. Although it feels as if we have been waiting a long time for interest rates to increase, the long term trend will likely be up. To prepare for higher rates, we believe you should manage portfolio duration, utilize bond ladders to include high coupon and callable bonds, maintain asset class, sector and credit quality diversification and remember to stay focused on long-term objectives while maintaining a portfolio that matches your risk tolerance.

CRN: 2016-0502-5323R

This commentary is for informational purposes only. All investments are subject to risk and past performance is no guarantee of future results. Please see the Disclosures webpage for additional risk information at https://www.aamlive.com/legal/commentary-disclosures. For additional commentary or financial resources, please visit www.aamlive.com.