It has been an eventful year for interest rates. After topping 2.6 percent in March, 10-year Treasuries fell sharply to just over 2.1 percent in late June before rebounding to their current levels of around 2.4 percent. These dramatic fluctuations highlight the high degree of uncertainty that characterizes the current environment.
After pricing-in a pro-growth legislative agenda early in 2017, interest rates recalibrated in the second quarter. As the prospects for growth-boosting policies from the Trump administration faded due to legislative setbacks and political missteps, the inflation outlook moderated, driving down interest rates.
After pricing-in a pro-growth legislative agenda early in 2017, interest rates recalibrated in the second quarter.
Then, toward the end of the quarter, the U.S. Federal Reserve sent stronger signals of its intention to begin unwinding its $4.3 trillion balance sheet and the European Central Bank sounded a hawkish tone on its bond-buying program. The expectation of a pullback on stimulus gave rates a boost, and today the prospect of higher interest rates looms over the market.
However, the potential for further interest rate volatility remains, and the broader economy presents a similarly uncertain picture. Most analysts have recently revised their optimistic U.S. GDP growth estimates downward. While the Fed believes that the economy is strong enough to justify raising rates, it is unclear how this will impact a market that has become reliant on easy central bank dollars. At the same time, despite a stable yet muted growth outlook, U.S. stock markets are trading at record highs. Investors thus face a slow growth, rising-rate environment and a stock market that may have limited upside.
What is the role of fixed income against this backdrop?
The reason to favor fixed-income assets in this environment is simple: they have a clear embedded or implied return. If an investor purchases a credit instrument, they can be reasonably confident about the returns they will receive: interest payments at a known rate and, ultimately, the return of their principal. This is in marked contrast to equities, where the return outlook is much more uncertain.
Dividends are not guaranteed, and the return of principal is predicated on stocks retaining their value. With stocks seemingly fully priced, the risk of a downturn appears elevated.
When it comes to fixed-income instruments, there is a risk of default. However, after a modest uptick in late 2015 and early 2016, default rates have stabilized at historically low levels of around two percent. Defaults in the oil and gas and commodities sectors drove the uptick, but the weakest players have since been culled and the remaining players have had the opportunity to repair their balance sheets. Thus, fixed-income instruments currently offer investors relatively predictable returns with modest risk, while the return profile for other assets appears more uncertain.
Asset selection matters
While fixed income offers investors a broadly attractive return profile, it is important to consider the impact that rising rates may have on these instruments.
Typically, credit assets that pay a fixed coupon see their values decline when rates rise, because their yields are lower compared to newly issued loans. This does not necessarily affect the ultimate repayment of the principal, but it causes investors’ fixed-income portfolios to decline in value. Holding fixed-coupon assets also limits investors’ ability to benefit from the income-boosting potential of rising rates.
Floating-rate loans are an attractive option to help mitigate the risks associated with rising interest rates. Floating-rate loans pay interest at a rate that is tied to a benchmark. When the benchmark rate increases, the rate that floating-rate loans pay increases too.
Typically, credit assets that pay a fixed coupon see their values decline when rates rise, because their yields are lower compared to newly issued loans.
Thus, selecting the right fixed-income assets is critical. Active management by an experienced manager may help investors to ensure that their portfolios include the best mix of assets.
And there is another good reason to favor active management at this point in the investment cycle. After an eight-year bull market underpinned by a loose monetary policy environment, assets across the board look fully priced. As the policy cycle turns and the bull market ages, a downturn grows increasingly likely.
Having an experienced manager actively selecting assets that may offer value or downside protection may help investors avoid losses in the event of a downturn. While those who hold passive funds will see those funds fall in line with the market (as they have risen in line with the market), those who hold active funds may be sheltered from the downturn to a degree.
At this point in the cycle, choosing the right fixed-income assets is vital. When assets are fully priced, returns may be driven by idiosyncratic security selection, underscoring the potential need for active management. Good asset selection may help an investor benefit from rising interest rates and avoid market-driven losses in the event of a downturn. As we enter the second half of the year, the outlook remains largely unchanged from the beginning of the year, but the downside risks are piling up.