Despite Higher Rates, Bonds Remain Attractive
It might seem counterintuitive that a year marked by higher economic growth, rate hikes by the Federal Reserve and a revamping of the U.S. tax code would be favorable for bonds. But that was the story in 2017 as mild inflation and restrained central bankers helped to underpin the market.
The members of our Bond Roundtable expect that positive momentum to carry into 2018, although they remain vigilant for signs of turbulence. Below, portfolio managers John Queen and Mark Marinella, and analyst Courtney Wolf, share their insights into the factors that have kept the fixed-income market on firm ground and discuss what may lie ahead in the months to come.
Bonds had a good year, despite a cumulative 0.75% increase in the fed funds rate. Why did they do so well, given this headwind?
Mark Marinella: Several reasons, including the fact that the Fed has been really good at cluing the market into its decision-making process and telegraphing where it’s headed. Equally important, the pace of rate increases has been well spaced out. All of this prevented the type of surprises that can shock investors.
John Queen: It’s important to point out that the Fed is still quite accommodative overall. In addition to boosting rates, the central bank is reducing monetary stimulus by cutting back on purchases of Treasury bonds and mortgage-backed securities. But that’s being done gradually, and the Fed is still a big buyer of both. Also, central banks in Europe and Japan still have aggressive bond-buying programs in hopes of lifting their economies. Finally, demand for U.S. Treasury bonds remains high among both pension plans and overseas investors. Though U.S. rates are low, they’re still much higher than what you can get in Europe and Japan.
Municipal bonds also fared well overall. Were you expecting more turbulence, given the cut in tax rates?
Courtney Wolf: Even though marginal rates were trimmed, the reduced deduction for state and local taxes has made many high-income earners question whether their tax bill will actually go down. That concern is especially pronounced in high-tax states like California and New York. In general, of course, higher effective tax rates tend to increase demand for muni bonds. Also, insurance companies and banks are heavy buyers of municipal securities, and they are likely to remain so, even with a lower corporate rate. Corporations like investing in munis because they have tended to offer attractive risk-adjusted returns and have had low correlation to some other asset classes.
The fixed-income market is normally fairly stable, but volatility was particularly low last year. How come?
Marinella: One reason is the stable economic environment. At this time last year, there was concern that the pro-growth policies of the incoming president would lead to increased growth and a potentially significant pickup in inflation. But although the economy edged up slightly, inflation was mild. It might tick up this year, but not enough to shake the market. So there’s a very low risk of the Fed having to abruptly jam on the brakes. That’s been augmented by the Fed’s transparency. The predictability of future Federal Reserve policy gives comfort to the market.
Queen: For those of us who’ve been in the market a long time, that’s new. It wasn’t long ago that the Fed not only didn’t disclose what it was going to do, it didn’t even reveal what it had done. It raised or lowered rates by adjusting the amount of liquidity in the system, and the market had to figure out what happened. There were whole groups of people who did nothing but watch the Fed to decipher if it had tightened or not. This new transparency has allowed for lower volatility, which is better for the economy and the financial markets.
As you look ahead to the rest of this year, what do you foresee for bonds?
Queen: I expect a continuation of what we have seen recently. We still have massive amounts of liquidity in the marketplace, and global central banks are pumping in more all the time. The Fed is likely to raise rates three times or perhaps even four. But that’s been well transmitted to the markets and will happen at a very measured pace. As long as conditions don’t change too much, such as a sudden breakout in inflation, it’s likely that rates will rise a bit but not that much.
Are you worried that the Fed might hike rates at a faster pace if tax law changes spur additional growth?
Queen: No, because any fiscal stimulus generated by tax cuts will probably just offset some of the monetary stimulus that the Fed is taking away. These two things should largely balance each other out, which could extend the low-volatility path we’ve been on.
Courtney, what’s the outlook for the municipal market in 2018?
Wolf: It’s a really exciting time to be in the muni market. Issuers that otherwise might have done deals this year rushed to do them in 2017 because they were uncertain about the impact of tax reform. That gave us a great opportunity to buy promising bonds for clients. Plus, that flood of issuance may result in lower supply this year, which would be another positive for muni valuations.
Given the current economic backdrop, how are you positioning client portfolios in terms of taxable bonds?
Queen: We’re pretty middle of the road, with relatively low-risk positioning. We want our clients to have the potential for protection in case of an unexpected shock. We hold a lot of securities that mature in five to seven years. These securities can provide a bit of a yield advantage compared with shorter-term securities. But if something goes awry — a breakout in inflation, a rise in volatility or an equity market decline — they have tended to hold up better than issues with longer terms.
Are there certain sectors you’re particularly attracted to at the moment?
Queen: We expanded holdings in the energy sector. Last year’s drop in oil prices allowed us to find higher-than-market spreads among energy companies. These are analyst-driven ideas where we think there’s some real value. Through our research, our team was able to identify financially sound companies where we have not identified credit risk. We also were drawn to offerings in the pharmaceutical sector, as well as in the asset-backed space, where we found very high-quality assets offering excess yield.
Mark and Courtney, can you provide a sense of how you are positioning municipal portfolios?
Marinella: We have similar positioning to what John mentioned and are sticking with very high-quality issues. We’re favoring shorter-term maturities, since you’re not being paid to go out further on the curve right now.
Wolf: The supply-and-demand dynamic for municipals has been very favorable for buyers, and we have taken advantage of that. We’ve found opportunities across a range of sectors. For example, I cover toll roads, where we’ve uncovered a number of interesting deals. We’ve also added water and sewer bonds, utilities and hospitals. Single-family housing has also been an appealing area as yields have become more attractive.
What are some risks that could disrupt your overall favorable outlook?
Queen: There’s always the danger of some kind of international incident or geopolitical issue — North Korea, the Middle East or Brexit. Any of these could throw a scare into the market. One of the more immediate issues could be China. We keep a close watch on China to understand its economy.
Marinella: I think it’s very unlikely to occur, but runaway inflation would be negative for stocks and bonds.
An issue that’s drawn attention lately is the possibility of a so-called inversion of the yield curve. Normally, longer-term Treasuries have higher yields than shorter-term issues, but the differential between short- and long-term yields has narrowed. Inversion — in which shorter-term securities actually yield more than longer-term ones — has historically been a precursor to recessions.
Queen: An inversion would probably mean that the Fed has overtightened — that inflation expectations haven’t increased at the same pace that the Fed has raised rates. It could happen, but it doesn’t seem likely in the short run. And while inversions have traditionally suggested a recession is coming, it doesn’t tell you much about the timing. In the 1990s, for instance, the curve was flat or inverted for two or three years and we didn’t get a recession until somewhat later. Although the outlook can change, at the moment all the pieces seem to be in place for another pretty good year in the bond market, with attractive yields and relatively low volatility.
The above article originally appeared in the Winter 2018 issue of Quarterly Insights magazine.