In 2016, equity markets ended the year on a high note. In 2017, investors must consider how to adjust their portfolios to account for significant changes in the economic backdrop.
First, and perhaps most importantly, we are at the beginning of a major shift in global monetary policy. Since the global financial crisis in 2008, central banks worldwide have pursued highly accommodative monetary policy, lowering interest rates to stimulate growth. However, as the economy continues to improve, central banks are beginning to take their foot off the gas. In the U.S., the Federal Reserve raised market rates by 0.25 percent this past December and signaled the potential for three additional hikes in 2017.
Second, there are significant fiscal changes on the horizon. The new administration under President Donald J. Trump has signaled potentially dramatic policy shifts. Paradoxically, at the same time the Fed has outlined a less accommodative monetary policy, the new administration has outlined a more accommodative fiscal policy, seeking to use tax cuts and government spending (i.e. defense, infrastructure) to boost growth.
While these measures may stimulate the economy, they pose a risk to fixed-income investors. Higher government spending and tax cuts can translate into increased federal debt, which could drive further interest rate increases. Additionally, if the economy gains momentum from these new measures, it could lead to inflation, which is potentially damaging to fixed-income investors because it erodes the value of fixed payment streams.
In short, 2017 appears to present a challenging backdrop for fixed-income investors. In particular, rising interest rates are bad news for investors whose portfolios are dominated by fixed-rate investments like corporate bonds, Treasuries, or municipals. When interest rates rise, fixed-rate assets take a hit because they must reprice to reflect new market values. Investors are left to either sell at a discount or watch the value of their investments slowly decline.
However, investors still need an allocation to fixed-income assets to provide much needed portfolio diversification, to help minimize volatility, and to generate the income return they desperately need. To enjoy these advantages while minimizing the impact of higher interest rates, investors should look for opportunities to invest in floating-rate assets.
One potentially attractive option is floating-rate corporate loans, also known as leveraged loans or senior secured loans.
Floating-rate loans pay an interest rate that is tied to a benchmark, specifically the London Interbank Offered Rate (LIBOR), plus a certain spread. For example, a loan may pay LIBOR with a 1 percent floor plus 3 percent, which would translate into a total coupon of 4 percent. If LIBOR is 1 percent, then that loan would pay 4 percent. If LIBOR increased to 1.25 percent, the loan would pay 4.25 percent. In this way, floating-rate loans actually provide investors higher income when rates rise, mitigating the impact of rising rates on fixed-income investments.
Beyond rising interest rates, inflation also poses a risk to fixed-income investors because it decreases the future value of current income.
When inflation is high, a bond paying $500 a quarter is less valuable than when inflation is low, because the value of that $500 will decrease each quarter. In an inflationary environment, then, floating-rate loans are a more attractive fixed-income option because their coupon payments may increase over time.
As you head into the new year, you should consider how much interest rate exposure you have in your portfolio and how develop strategies to address interest rate risk.
As investors head into the new year, they should carefully consider how much interest rate exposure they have in their portfolios and develop strategies to address interest rate risk. In addition to traditional fixed-income investments like fixed-rate corporate, Treasuries, and municipal bonds, many investors may be holding so-called “bond proxy” investments like dividend-paying stocks in industries such as consumer staples and utilities. In addition to lofty valuations, these investments are also vulnerable to interest rate risk, much like their fixed-rate bond counterparts.
In the face of rising interest rates, investors should reassess their portfolios and consider switching to floating rate, fixed-income alternatives that may be better positioned to cope with today’s new economic realities.