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Date: October 22, 2018
Category: Credit

Q3 2018 Credit Report: Rising Rates Continue to Hamper Increasingly Illiquid Fixed-income Market


The Federal Reserve continues to follow the script, raising the fed funds rate by another 25 basis points at its recent September meeting, its eighth interest rate hike since 2015. This predictability follows the economy’s lead, with strong economic news continuing to guide the path to rate normalization.

Gross domestic product (GDP) increased at an annualized rate of 4.2 percent last quarter, the fastest growth rate since 2014, while unemployment sits below four percent in a labor market quite literally out of workers. The Labor Department recently announced that filings for unemployment benefits fell to a 48-year low. There are more job openings than available workers – 11 openings per 10 unemployed workers – while Americans are also quitting at their highest rate since 2001, a strong signal of more promising job prospects. This tight labor market is finally starting to lift wages, as average hourly wage growth increased 2.9 percent year-over-year in August, the sharpest jump since June 2009.

Inflation, like wage growth, had been mysteriously absent during this lengthy expansion until recently. Core inflation, as measured by the Fed’s preferred benchmark, the index for Personal Consumption Expenditures (PCE), is now sitting right around its two-percent target.

We believe that the market’s default position should assume (absent a disruption) a 25-basis point rate increase each quarter into 2020. However, there are signs of price pressures, which could prompt the Fed to hike more aggressively.

The Trump administration recently announced tariffs on over $500 billion of Chinese goods, which could strain the availability – and therefore the cost – of goods. Tariffs will begin at a rate of 10 percent, but could increase to 25 percent next year.

The rate differential between the United States and Eurozone has driven demand for the U.S. dollar in recent months, which has helped keep inflation in check. This dynamic may soon shift. This summer, the European Central Bank announced that it will conclude its quantitative easing program at the end of 2018 and indicated the potential for rate hikes in 2019. Less accommodative monetary policy in Europe could lessen U.S. dollar strength and unleash pressure on overseas goods.

In short, the backdrop portends continued struggles for traditional fixed-income vehicles.

Is a liquidity crisis next?

Outside of interest rates, there is another possible peril for bond investors. Since the financial crisis, the world has experienced nearly a decade of credit creation supported by central bank liquidity. We would argue that credit has guided the current economic cycle. Corporate debt sits at a level that has coincided with previous recessions. In the next downturn, after years of absorbing debt instruments, investors will inevitably look to sell.

But here comes the tricky part: to whom? Before the financial crisis, investment banks provided liquidity to global credit markets. The Volcker Rule and other regulatory hurdles have removed these “too big to fail” institutions from their role as market makers.

Liquidity risk has now been “socialized” in a sense, pushed down to buyers and sellers. Investors now hold this risk in their portfolios. As we saw in the Taper Tantrum in 2013 – which experienced a sudden re-pricing of credit and sent tremors through emerging markets – the deterioration of credit market liquidity can lead to rapid price deterioration.

So, what happens next? Retail investors, unfortunately as the next downturn will reveal, predominantly gain exposure to the bond and loan market through daily liquid mutual funds.

When the music stops, these funds may experience sudden downward price gaps in the value of the holding accelerated by little liquidity. At the same time, these funds may face a wave of redemptions from investors trying to sell. These funds will have only one means to meet these redemptions: selling their underlying bonds and loans into a panicked market.

With major investment banks sidelined by regulation and smaller banks lacking the capital to absorb the risk from a massive selloff, individual retail investors may pay the price. Under those circumstances, even the most highly liquid bond markets may not hedge against portfolio risk.

Positioning portfolios for today’s risks

Investors must be cognizant of the key risks facing fixed-income investing, including continued rate hikes and an increasingly illiquid bond market. Corporate bonds have experienced diminishing returns of -1.60 percent year-to-date through September, due in part to their fixed coupons.1 Buying bonds as rates rise comes with an opportunity cost of capital. If rates continue to climb, bonds bought today will come down. Instead, investors should examine floating-rate assets, which pay higher interest as rates rise, helping reduce interest rate risk. Also, give consideration to the liquidity risk in fixed-income portfolios. The interval fund structure creates a long-term capital base, and more importantly, likely allows a fund to remain fully invested during market dislocation. An interval fund can then take advantage of cheap prices, while many liquid bond funds are selling at losses to satisfy redemptions.

1 Bloomberg. Barclays US Aggregate Total Return Index. 1/1/18-9/30/18.

Resource Securities LLC, Member FINRA/SIPC.

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