After the strong jobs report on November 6th, it’s looking like the Fed might finally have some data to justify in their minds making their first interest rate increase. With that, the December rate hike is starting to look more and more likely. So it is time to abandon the fixed income market? Not necessarily.
First we want to get back to our take that while the Fed wants to start taking some action, we don’t expect them to be aggressive in their rate hikes. Be it one and done or a few in 2016, we don’t see a huge increase in rates. By all indications, they have wanted to act for months and months, but are just now getting the data support to make the first step happen. While we are seeing a few signs of economic improvement, the reality remains that we are in a no growth world with rates in developed nations around the globe much lower than ours (see our piece “Life in a No Growth World and the Impact on Interest Rates”), there is still a large contingency of underemployed or people that have abandoned looking for a job altogether domestically, and the Fed can talk all they want about the low inflation being “transitory,” but this low commodity and energy price environment appears to be here to stay for the time being.
Fed rate action means that the Federal Funds Rate will increase, but that is merely an interbank lending rate. So while the Fed is impacting the Federal Funds Rate, what really matters for us as investors is the 5- and 10-year Treasury rates. Just what will happen to those more relevant rates? We have seen a recent pop in Treasury rates in anticipation of Fed action, but as we expect the Fed’s actions to be moderate, we also expect that we won’t see a huge spike these Treasury rates for many of the same reason outlined above, and given markets are forward looking, we may have already seen much of the rate impact.
Getting back to the question, is it time to head for the exits on fixed income? There are certain sectors of the fixed income market that are more sensitive to interest rate changes and have a higher duration (as outlined below), such as investment grade and municipals, so it may well be worth investors evaluating those exposures. But the lower duration, higher yielding non-investment grade market has historically fared well in rising rate periods, overall posting strong returns during the annual periods in which we have seen rates rise over the last 30 years (see our piece “Strategies for Investing in a Rising Rate Environment” for further details). We’ve written at length about the subject over the last year, but let’s revisit the main reasons why we believe the high yield market is positioned well in this environment:
Higher coupons and yields in the high yield space help cushion the impact of rising interest rates.
- The higher the starting yield, the less impact we would expect to see from a move in interest rates.
High yield bonds have shorter durations than other asset classes in the fixed income space.
- Duration is a measure of price sensitivity of a bond to changes in interest rates, which incorporates the coupon, maturity date, and certain call features.
- High yield bonds are typically issued with five to ten year maturities and are generally callable after the first few years, as well as offer higher coupons, providing the high yield sector with a shorter duration, thus theoretically less interest rate sensitivity versus other fixed income asset classes.1