Q&A: Positioning for rising rates (at some point!)

05-21-2014

It’s been tough to get a read on the bond market this year, as Treasuries have remained surprisingly range-bound while spreads on high-yield and investment-grade corporate bonds have been below historical medians. We asked William Ehling, a Federated fixed-income market strategist, to share his insights.

Q: Bill, before we begin, perhaps you could first share the fixed-income team’s macro and policy outlook? Our allocation and duration recommendations are based on the assumptions that domestic growth will continue to improve, with real GDP expanding approximately 2.5% this year; that the Fed will continue to taper each and every meeting, putting quantitative easing behind us by the end of October; and that no exogenous shocks emanate from either Europe or Asia.

Q: Given this backdrop, which fixed-income asset classes offer the best opportunities and which should be avoided? We think high-yield and investment-grade corporate bonds, with duration no longer than the intermediate range—4 to 6 years and in—still present attractive relative value opportunities. Floating-rate securities also offer the potential for protection against rising rates. We’d avoid overweighting U.S. Treasuries, mortgage-backed agency securities and generally longer maturity/duration products which seem to present significantly more risk than reward at this juncture.

Q: When might it be appropriate to extend duration on fixed-income investments, i.e., grab yield on the longer-end of the curve, without worrying too much about the potential for capital destruction (rising rates/falling prices)? As the recent rally in U.S. Treasuries shows, the market and the media appear to have jumped the gun on the “rising-rate environment.” Historically, the gun goes off on such an environment when the Federal Reserve feels it has the latitude to raise its target funds rate for the first time, which recent statements and current language suggest isn’t likely until mid-2015 or so.

Of course, the market doesn’t wait for the first policy move to increase rates across the yield curve. In the 2003-06 cycle—which began when the Fed lowered its target rate to 1% in June 2003, followed by a series of rate hikes beginning a year later and ending with a peak of 5.25% in June 2006—the 10-yield traded as low as 3.07% on a deflationary scare in June 2003, spiked to 4.69% in September 2003, fell back in a counter-trend rally (much like we’ve seen recently) to 3.70% in March 2004, and was back to 4.89% in May 2004 before the Fed actually first raised its target rate in June 2004 to start that cycle.

I think you’ll get comparable price action this time around, assuming our macroeconomic outlook is correct, which would suggest 10-year Treasury yields will cheapen up enough (i.e., rise enough) to provide an opportunity to buy longer duration paper before the Fed’s first rate hike. The slope of the yield curve, or the differential between the target funds rate and 10-year yield, has never gone through 400 basis points. This would indicate we’re probably talking about opportunities to stretch duration if 10-year yields are more than 3.50%.

Q: Final thoughts? It is worth remembering that market forecasts are like weather forecasts: They lose validity the farther out you go in time. It is also worth remembering that all the media noise to the contrary, bonds arguably aren’t in a bubble—particularly if fixed-income investors are in products that are no more than intermediate in duration. With short-to-intermediate durations, a bad year in bonds is a bad day in the equity market. The historical record also shows that when you have a macroeconomic shock like our financial system had in 2007-2008, low rates are the norm. They’re necessity to cure the patient, i.e., to get the economy back on its feet. That’s what we’ve been dealing with and likely will continue to deal with for some time.

Thanks, Bill.


 
 
 
 
 
 
 
 
 
 
 
Views are as of the date above and are subject to change based on market conditions and other factors. These views should not be construed as a recommendation for any specific security or sector.
Bond prices are sensitive to changes in interest rates, and a rise in interest rates can cause a decline in their prices.
Diversification and asset allocation do not assure a profit nor protect against loss.
Duration is a measure of a security's price sensitivity to changes in interest rates. Securities with longer durations are more sensitive to changes in interest rates than securities of shorter durations.
Gross Domestic Product (GDP) is a broad measure of the economy that measures the retail value of goods and services produced in a country.
High-yield, lower-rated securities generally entail greater market, credit/default and liquidity risk and may be more volatile than investment-grade securities. For example, their prices are more volatile, economic downturns and financial setbacks may affect their prices more negatively, and their trading market may be more limited.
Investment-grade securities are securities that are related at least "BBB" or unrated securities of a comparable quality.
The cash-yield curve is a graph showing the comparative yields of securities in a particular class according to maturity. Securities on the long end of the yield curve have longer maturities.
The value of some mortgage-backed securities may be particularly sensitive to changes in prevailing interest rates, and although the securities are generally supported by some form of government or private insurance, there is no assurance that private guarantors or insurers will meet their obligations.
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