By Portfolio Managers, Kevin Kelly & Kevin Strauss
With interest rates at post global financial crisis highs, fixed income currently provides very attractive potential returns. Investment grade yields are near the highest level in 14 years at approximately 6%, while core PCE inflation is down to 4%, even if inflation is still above the Fed’s 2% target. We would also highlight that investors do not need to take excessive risk in fixed income when the majority of yield is currently driven by interest rates (reminder: yield = interest rate + credit spread). Chasing lower quality credits in the current interest rate environment elevates the risk of a portfolio, as these companies could run into issues if they have to refinance their debt at much higher interest rates during a potential economic slowdown or recession. Overall, we think the short to medium-term outlook for investment grade bonds is positive with a nearly 6% yield to help protect against any future potential increases in interest rates. Moreover, if rates decline, fixed income investors will be rewarded with earning above market yields.
The Fed’s rate hikes are nearing an end, but how long the Fed will maintain a Fed Funds rates at 5% or higher is still to be determined. The Fed does not want to lose the battle against inflation, and it will do its best to anchor long-term inflation expectations as close to 2% as it can. While the Fed may not be done raising rates, we do not foresee a situation in which the Fed Funds rate approaches 7%, but with the Fed Funds range currently at 5.25-5.50%, an increase to 6% can’t be ruled out. In our opinion, there is a higher likelihood of economic stress if the Fed is compelled to raise rates higher or hold at current levels for an extended period of time. In this case, short-end rates (0-3 years) could decline abruptly. Unless the economic stress is severe, we would expect the 10-year and 30-year Treasury rates would likely only be marginally influenced by such a scenario. If the economy maintains positive growth, certainly if it expands around 2%, the Fed Funds rate may not decline any time soon. However, interest rates holding steady is more than compelling enough to warrant buying investment grade bonds yielding approximately 6%.
Investors often forget the Fed does not control intermediate or long-term Treasury rates, which are the rates that drive bond prices. Bonds are not priced off the Fed Funds (overnight) rate. So even if you think the Fed is going to raise rates one or two more times, this does not mean you have to wait to invest in fixed income.
We would discourage attempts to call a peak in rates and choosing to add signification duration risk (interest rate) by overweighting 10–30-year bonds. Having a view on interest rates is essential to fixed income investing, but recognizing which way the risk is skewed and reflecting that in a portfolio is extremely different than going all-in. While precisely predicting interest rates is very difficult over a sustained period, we are confident that we can repeatedly do solid credit research, select attractive securities, and successfully manage the portfolio. Many investors are only buying very short-dated securities or sitting in money market funds which creates significant reinvestment risk if/when short-term (0-3 years) interest rates decline. Eventually short-term rates will peak and will decline. Once again, this is trying to time rates which we discourage. For those wondering why should they invest in fixed income today versus waiting, the balance of risks has tilted so there is a higher probability of short-term rates decreasing than increasing over the next 12-24 months. If short-term Treasury rates stay flattish or increase slightly, investors would still be earning a 6% yield in intermediate, investment grade bonds versus money market yields close to 5%. (Note the inverted yield curve has resulted in money market yields in excess of 3, 5, 10, and 30-year Treasuries. If the Treasury rate curve normalizes this would no longer be true.)
Given the substantial interest rate increases in the past two years, every investor is asking when and how will rates go down. We think it is important to distinguish between short-term interest rates (0-3 years) and long-term (10+ years), because the factors driving each are quite different. Short-term interest rates will be most heavily influenced by current economic conditions domestically and the prospect of Fed action with policy. There is a massive bias in the U.S. to focus on the domestic economy and not enough on the global economy. In contrast, long-term rates are heavily influenced by long-term global financial forecasts of growth and inflation. We can’t emphasize enough the importance of thinking globally regarding long-term rates. Interest rates in Europe, Japan, and other developed countries will determine how compelling it is to own U.S. Treasuries for foreigners. Like the U.S., most other global central banks maintained very accommodative monetary policies for several years prior to Covid. One extreme example is Japan, which currently has a 10-year government bond still yielding below 1%. But can the country continue such a policy endlessly? It seems unlikely. Besides global rates, U.S. government deficit projections remain extremely high. This means Treasury yields must attract significant additional buyers. Therefore, we are more confident that short-term rates (0-3 years) will eventually decline once inflation slows or during the next recession, while the case for a sizable decline in long-term rates (10+ years) is far less clear as the number of factors that influence long-term rates is much larger and global.
We recognize that navigating a rising rate environment is not easy, but interest rate risk can be managed. We continue to favor an investment grade fixed income portfolio with an intermediate duration. Buying very short-dated securities creates significant reinvestment risk if/when short-term interest rates decline. On the other hand, buying all very long-dated securities exposes investors potentially to both rising long-term interest rates and widening credit spreads. Investors who need to sell prior to maturity could potentially lose significant principal in such a scenario. Fixed income is arguably the most compelling it has been in 14 years, so we encourage investors to consider whether their fixed allocations remain appropriate for them. Finally, the opportunity cost of excess cash is simply too high to not take action even if the right solution for you is to be extremely conservative.
The foregoing content reflects the opinions of Advisors Capital Management, LLC and is subject to change at any time without notice. Content provided herein is for informational purposes only and should not be used or construed as investment advice or a recommendation regarding the purchase or sale of any security. There is no guarantee that the statements, opinions or forecasts provided herein will prove to be correct. Past performance may not be indicative of future results. Indices are not available for direct investment. Any investor who attempts to mimic the performance of an index would incur fees and expenses which would reduce returns. Securities investing involves risk, including the potential for loss of principal. There is no assurance that any investment plan or strategy will be successful.