On March 20, 2017
AAM Viewpoints – Lessons Learned from Rising Rates
With the third rate hike in the current Federal Reserve tightening cycle in the books, higher rates moving forward seem a forgone conclusion for most market observers. The Fed hike on March 15 represents the second hike in the last 90 days and a significant increase in the pace of hikes relative to the 12 months (12/14/2015-12/16/2016) that transpired between the first and second hike. This is in no small part due to significant improvements in the global economic landscape since this first Fed hike as well as building inflationary forces around the world stoked by the prospects of fiscal stimulus in the United States after the presidential election. Expectations for an increase in the pace of Fed hikes should come as no surprise given recent developments on the inflation front especially given that we are nearing the Fed’s 2% goal even before the enactment of potentially pro-growth inflationary policies by the current U.S. administration.
These developments have many portfolio managers, economists and market observers calling for a significant increase in interest rates over the next few years with some calling for levels as high as 6% on the U.S. 10-Year Treasury over the next three years. So what should one expect with regard to performance in fixed income markets? Should we see another sharp move up in rates from current levels? Furthermore, what can one ascertain from expected performance to guide security selection and asset allocation of a fixed income portfolio in a rising rate environment? An analysis of recent performance in fixed income markets may provide some guidance.
Since touching an all-time low of 1.38% on 7/08/2016 the U.S. 10-Year Treasury yield is up almost 115 bps (basis points) moving from 1.38% to 2.50% as of 3/15/2017. If we were to see a 6% 10-year yield by 2020 – which would be an increase of 350 bps – it would require an average yearly move of approximately 115 bps. (350/3 = ~116 bps) Under a scenario in which we see 115 bps increase per year, one would expect annualized fixed income returns for each of the next three years to be comparable to the realized holding period returns we have seen since touching lows on 7/8/2016.
TSY = Treasury Yield; IG = investment grade corporate bond; BBB rated = lower/medium grade; HY = high yield corporate bond
Source: Bank of America/Merrill Lynch Indices | Past performance is not indicative of future results.
Two very important observations can be made relative to the recent performance in fixed income markets. First, weighted average coupons look to play a large role in returns and the larger the weighted average coupon the better returns have been during a period in which rates have risen by over 100 bps. This should come as no surprise as income return on a fixed income instrument tends to be the largest source of return over longer time frames. This has certainly held true since the market highs on 7/8/2016 with the best performer being High Yield, which also carries the largest weighted average coupon of the group and the worst performer being Treasuries, which carry the lowest weighted average coupon. Since weighted average coupon equals income return when looking at annual time frames, one should look at coupon or income return as offsetting price return losses which occur during periods of rising rates. In addition to providing a total return cushion, higher coupons also tend to be less sensitive to interest rates as there is a negative relationship between coupon and duration with duration falling as coupon rates increase, all other things being equal. This negative relationship reflects the fact that higher coupons generate higher levels of current income allowing for faster reinvestment at prevailing rate levels which in a rising rate environment reduces sensitivity to interest rates. Under this framework it is not a leap to expect fixed income asset classes such as corporates, with 4% or better weighted average coupons, to outperform asset classes like Treasuries which carry modest coupons of less than 2.5%. High Yield, which carries one of the highest weighted average coupon rates in the fixed income universe has held up quite well during periods of increasing rates due in no small part to the income-return cushion that comes via higher coupons.
Past performance is not indicative of future results.
This brings us to a second important observation with regard to recent performance in the fixed income markets and further explains the recent outperformance in High Yield. Credit-sensitive fixed income tends to outperform during periods of rising rates when rates move up on the basis of a healthy economy. Unlike previous rate increases post-2008, the recent move up in rates looks to be supported by improving U.S. corporate earnings, healthy U.S. labor markets, increasing expectations in regards to inflation and expectations for GDP growth. Under this scenario you would generally see falling corporate default rates or the expectation of falling default rates and this has been the case since mid-2016.
Source: Moody’s Investor Services
As economic conditions improve investors demand less compensation for taking on credit risk and credit spreads tend to narrow minimizing price return losses versus less credit sensitive fixed income. This is reflected in performance since 7/8/2016 as Investment Grade (IG) corporates have outperformed Treasuries, which include no credit compensation, even with significantly longer durations. This is due to credit spreads narrowing by approximately 34 bps. The lower quality, more credit-sensitive areas of the IG market, such as BBB bonds, have fared even better outperforming the balance of the IG markets with spreads tightening 49 bps. High Yield, one of the more credit sensitive areas of the fixed income markets, has performed admirably with spreads tightening by 183 bps since 7/8/2016 generating a positive price return of almost 3% even with rates moving up by over 100 bps. While there is a limit to spread tightening and spreads do widen at times during periods of rising rates it is certainly not a stretch to expect more credit sensitive fixed income to outperform asset classes such as Agencies and Treasuries as rates increase.
With an expectation for higher rates on the horizon we feel the higher coupon, more credit-sensitive nature of asset classes such as corporates will lead to continued outperformance versus asset classes with smaller coupons and little to no credit compensation such as U.S. Treasuries. While no bond is immune from rising rates, it is possible to significantly reduce a fixed income portfolio’s sensitivity to increasing interest rates. Maximizing coupon and taking on credit risk are two ways to help achieve this aim and are supported by recent returns in fixed income markets. It is important to keep in mind that credit risk exposure should take place on an informed basis supported by credit analysis and proper diversification. In addition, credit risk can entail more volatility during periods of financial distress and might not necessarily be appropriate for all risk tolerances.
CRN: 2017-0306-5846 R
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 commentary-disclosures. For additional commentary or financial resources, please visit www.aamlive.com.