Keeping a Watchful Eye in a Rising Rate Environment
After nearly three decades of relative calm in the fixed-income markets, bond volatility may be back. The Federal Reserve enacted its second rate hike in 10 years in December, bringing its target to a still-low range of 0.50% to 0.75%. Even before that, rates had begun to move higher on fears of the potential inflationary ramifications of President Trump’s expected economic agenda.
Despite this uncertainty, our fixed-income and macroeconomic professionals insist that bonds remain an important component of diversified portfolios. But they caution that selectivity and experience in navigating ever-changing markets are essential moving forward.
Taking part in this year’s Roundtable discussion were Capital Group fixed-income portfolio managers Aaron Applebaum, Mark Marinella, John Queen and Tara Torrens, along with economist Jared Franz and Michelle Black, head of our Wealth Advisory Group.
Jared, how does the U.S. economy look from your perspective?
Jared Franz: I’m in the camp that we’ll continue to see cyclical improvement in 2017. We’re at full employment, and wages are rising. Near-term recession risks seem low, particularly based on historical trends. To the extent that President Trump gets some of the stimulus measures he wants, that could add 2 percentage points to growth, although I think that’s high when partial offsets are considered. It’s likely we’re moving toward an economy with around 2.8% growth in 2017 versus 1.9% in 2016.
What are the biggest risks?
Franz: To me, it’s still China. The country’s debt continues to accumulate, and that could add to further strengthening of the U.S. dollar. I also worry that a huge infrastructure package combined with massive tax cuts could cause inflation to heat up faster than expected.
Bond yields began to rise meaningfully after the election, even before the Federal Reserve enacted its hike in December. This was partially based on inflationary fears. John, what are your thoughts?
John Queen: Actually, we’ve seen higher volatility in the bond market several times over the past few years. It happened in 2015 and during the taper tantrum in 2013. But the question is whether this is the beginning of a more sustained normalization where you could ultimately see 10-year Treasury yields go up to 4% or 5% from around 2.5% today.
Queen: That’s still an open question. If you look at what caused rates to increase, it was a combination of good economic numbers and inflation expectations, given some of President Trump’s planned policies. Tax cuts and infrastructure spending both could be inflationary, particularly in an environment where we already have full employment and are nearing the Fed’s target inflation numbers. It’s one of the reasons the Fed cited for not only raising rates but implying there could be three more hikes this year.
Do you anticipate that will happen?
Queen: I expect the Fed to be less aggressive than indicated, which is consistent with the pattern we’ve seen in recent years. The Fed is concerned about global growth, the impact of a stronger dollar on the U.S. economy, the sustainability of inflation and the long-term impact of the 2008 financial crisis. I do think we’ll see more than one hike this year, but what’s fascinating is that chair Janet Yellen seems to be conveying a less dovish view than before [a position that favors low rates in order to help the economy grow]. We’ll have to watch the Fed’s rhetoric from here very closely.
Mark Marinella: I agree that anticipating at least two hikes this year is very reasonable. Could it be more? That depends on what kind of fiscal stimulus gets enacted. There is still fragility in the economy left over from the financial crisis, and that puts a bit of a cap on how aggressive the Fed can be. For instance, while wages are up, labor force participation is still quite low. Mortgage rates have jumped about 1% from the bottom, and that could impact whether people buy homes. If the Fed were to get more aggressive, it could slow an already fragile economy. The Fed knows that.
The housing market by and large has been strong in recent years, driven partly by historically low mortgage rates. Are you worried about a slowdown?
Aaron Applebaum: Trump’s election in many ways was a reflection of our two-toned economy. Housing in a lot of metro and urban areas has done well because employment and wages have been strong. I think those markets may continue to be okay, even with higher rates. But places that have lagged on employment and wages could be hurt further by rising rates because affordability was already an issue.
How would you rate Fed chair Janet Yellen’s performance at this point?
Marinella: That’s hard to answer. Yellen and her fellow board members have been effective enough to keep the system from crumbling, but not perfect by any means. If I had to give Yellen a grade to this point, I’d probably give her a “B.”
The municipal market seemed to be hit particularly hard by the rise in rates. Is there reason for concern?
Applebaum: This is the fourth time since 2008 that we’ve had a meaningful back-up in municipal rates, and each one has been a buying opportunity. The municipal market is particularly sensitive to flows, and we saw investors step back a bit after the election as they digested the potential impact of a Trump presidency.
The high-yield market was remarkably strong by comparison. Tara, that’s your area of expertise.
Tara Torrens: In many ways, 2016 was a mirror image of 2015 for the high-yield market. It was strong for a couple of reasons. The first is that you saw a rebound in commodities, which are well represented in the taxable high-yield space. Whether it’s metals and mining or some of the energy names, valuations had priced in so much distress that once you saw stabilization in the underlying commodities, it sparked a big rally. In addition, moderate GDP growth is very good for the high-yield market. Plus, there has been a general reach for yield around the globe.
Many pundits have come out since rates began to rise and stated that the 30-year bull market in bonds is over. Do you agree?
Applebaum: It’s too early to tell. The more important question is whether we’re in a new paradigm, and we won’t know that for another six to nine months. Absent some significant fiscal stimulus, it is likely rates will remain low, given global growth trends.
If rates do keep rising, does it still make sense for certain investors to hold bonds?
Queen: Absolutely. You really need to step back and remember why you hold bonds in the first place, which is to help hedge equity volatility and give you a smoother investment ride. Regardless of what happens with rates, bonds will continue to play that role.
Marinella: That’s a critical point. The role of fixed income in a diversified portfolio doesn’t change because rates might rise. Bonds can serve as a portfolio anchor, and they have historically done very well when equity markets have corrected. Bonds also tend to provide income, and as rates rise we are able to reinvest at higher rates. It’s interesting because when bonds pull back even slightly, people get nervous and start to talk about selling. I’d suggest reframing this a bit: If the equity market were to correct, would you sell all of your stocks? Of course not. We know over the long run that would be a very bad idea, and the same is true with bonds. Fixed-income securities play precisely the same role today as they always have, notwithstanding where rates may be headed.
But given the changing rate environment, have you altered your recommended allocation to bonds when constructing client portfolios?
Michelle Black: In general, no. Our long-term planning assumptions have suggested for some time that fixed- income returns will be muted given the expected rise in rates. We periodically review client portfolios to assess whether changes need to be made in order to help reach one’s financial goals. But a lower outlook for bond returns in itself is not necessarily a reason to decrease one’s fixed-income exposure. Our view, as John pointed out, is that a diversified portfolio of quality bonds historically has been the best insurance against equity market declines. That doesn’t change based on what’s happening with rates.
John, how are you positioning taxable portfolios going into 2017?
Queen: We’ve been targeting parts of the yield curve that we think are more attractively priced. Currently, that’s on the shorter end — around two years — where expectations for a rate rise are already baked in. We also continue to think that Treasury Inflation-Protected Securities, or TIPS, can add real value to portfolios, particularly as the economy balances the prospects of fiscal stimulus and inflationary pressures. Mortgages are becoming more interesting as rates back up. We also continue to like asset and commercial mortgage-backed securities. That said, we will need to carefully watch portfolio exposures as the year progresses.
What interests you on the municipal side, Aaron?
Applebaum: In the context of intermediate municipal portfolios, we’re focused on the one- to 10-year part of the curve. We continue to find interesting ways to capture yield without taking significant credit or interest rate risk. One example is through what are known as planned amortization class mortgage-backed securities, which typically come with government guarantees. We also still heavily favor revenue over general obligation securities, such as tax-assessment, water and sewer bonds.
If tax rates fall as expected this year, will that decrease the attractiveness of municipal bonds?
Marinella: Tax policy is always changing, and each time we see a similar reaction. But over longer time periods, there has been very little correlation between municipal performance and tax rates.
Applebaum: Interestingly, we may see a bigger reaction if corporate tax rates fall, since many corporations buy tax-exempt securities for the same reason individuals do. But that risk is more likely to play out on the longer end of the curve.
Queen: It’s also worth noting that with effective research it’s possible to find municipal securities with yields similar to taxable bonds. So even with lower tax rates, you’re still often better off owning munis.
What attracts you in high yield, Tara?
Torrens: We’ve been spending a lot of time on health care and pharmaceutical bonds. With these industries in the headlines a lot lately, it has created some significant spread widening. We are being very selective because there will clearly be winners and losers, but that’s where having a global research team to do in-depth fundamental analysis comes in.
Marinella: To that end, we’re in a time where many things are or may be changing. We have a new presidential administration with different policies, interest rates are trending higher, and the Fed is less dovish. All of that will create continued volatility in the market. Therefore it’s important to maintain a long-term perspective and not dwell on the news of the day.
Queen: As volatility increases, you need a careful eye and in-depth analysis to sort out the opportunities and risks in the markets, especially as fundamentals shift.