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Date: October 30, 2017
Category: Credit

Q3 2017 Credit Outlook: The End of Quantitative Easing and Fixed-income Portfolios [Commentary]

quantitative easing ending bubble bursting

The last few months have been a roller coaster for interest rates, yet this short-term instability masks an upward trend driven by monetary policy changes.

ten year treasury rates chart

 

In our view, the evidence clearly indicates that we are in a rising rate cycle. In her September testimony, Federal Reserve Chair Janet Yellen signaled that the central bank would raise rates once more this year, bringing the total number of rate hikes in 2017 to three. The Fed further indicated markets should expect three hikes in 2018. In both 2015 and 2016, we experienced only a single rate increase. The uptick in the pace of rate hikes indicates a clear shift in monetary policy.

More importantly, Yellen also announced that the Fed will finally begin winding down its balance sheet.

During the financial crisis, the Fed accumulated a $4.3 trillion portfolio of mortgage and Treasury assets in a process known as quantitative easing (QE), which was intended to help drive down rates. In 2014, the Fed ended its buying program. However, it has maintained its balance sheet; when assets reach maturity, they have been replaced dollar-for-dollar, so the Fed has continued to provide an important source of market liquidity.

In September, however, Yellen confirmed that the central bank would start running down its balance sheet at a rate of $10 billion a month. For the last decade or so, the Fed has been a reliable source of liquidity, helping to keep rates low. As the Fed starts to reduce its holdings, this liquidity support will reverse and rates will move higher.

A similar process is underway in Europe. The European Central Bank (ECB) has been pursuing its own aggressive QE program, buying about €60 billion of bonds a month and amassing a balance sheet of around €2 trillion.

In September, the ECB announced that it would end its QE program over the next few months and begin unwinding its balance sheet as early as next year. This means a second vital source of liquidity is withdrawing from credit markets, which should further boost interest rates.

We may also see some support for higher rates from fiscal policy. Attempts to repeal the Affordable Care Act (ACA) have failed and the Republican-controlled Congress is eager to chalk up a win before the 2018 midterm elections. Given this motivation, it is likely that we will see at least a modest package of corporate and individual tax cuts by the end of the year.

The White House’s proposed tax plan relies on economic growth to offset the cost of tax cuts. However, at least in the short-term, there is not likely to be enough growth to cover those costs. Therefore, the tax cuts will probably initially be financed by an increase in the federal deficit. Deficit spending means that the government will have to increase borrowing, which is likely to drive up interest rates further, especially when combined with a less accommodative monetary backdrop.

In short, virtually all key developments in monetary and fiscal policy are pointing to rising rates. For traditional fixed-income investors, this poses a challenge.

In short, virtually all key developments in monetary and fiscal policy are pointing to rising rates. For traditional fixed-income investors, this poses a challenge.

[Related:Hear portfolio manager Michael Terwilliger’s audio summary of this Commentary]

As rates rise, credit assets that pay a fixed rate of interest lose value. Fixed-income investors may therefore see the value of their portfolios fall. They may also find that their fixed-rate portfolios fail to deliver the rising income they are seeking.

This underscores the value of floating-rate assets like corporate loans. Floating-rate assets pay interest tied to a benchmark, and when the benchmark rate rises, these assets pay more. They can thus help protect the value of an investor’s principal in a rising interest rate environment.

However, it is important to select assets with caution. As interest rates rise, the risk of defaults may rise for less creditworthy issuers. Default rates currently remain muted, but investors may be wise to focus on assets that offer an additional layer of default protection.

For example, senior secured loans enjoy a senior position in the capital structure and are generally secured by borrowers’ assets. In the case of default, recovery rates for these loans have been historically much higher than those of more-junior and unsecured loans.

corporate debt recovery rates chart

 

Interest rates are rising. Fixed income investors may be wise to act now to protect their portfolios from the threat of rising rates by investing in floating-rate assets. These assets may offer rising income and capital preservation. Investors may also consider seeking out the additional risk mitigation offered by senior loans.

 
This information is educational in nature and does not constitute a financial promotion, investment advice, or an inducement or incitement to participate in any product, offering or investment. It is not intended to be used as a tool to determine your specific financial situation, tax status, investment objectives, investment experience, suitability for any specific investment, risk tolerance or investment profile. Resource is not adopting, making a recommendation for or endorsing any investment strategy or particular security. The materials included herein are the property of Resource and may not be repurposed in a separate likeness without the express written consent of Resource.

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