Market Perspectives - January 2014

Outlook 2014: Are we in the eye of the storm?

Fixed income

By James Kochan, Chief Fixed-Income Strategist

Our advice to fixed-income investors for 2014 remains the same as it was a year ago. Because we believe it is still too early in this investment cycle to employ defensive strategies, income—not safety—should, in our opinion, remain the primary investment objective in the year ahead.

We are frequently reminded that this is a minority view. The consensus advice is to avoid bonds in favor of short-duration sectors to avoid negative returns once interest rates start to rise. In our view, that gives too little weight to three important points:

1. In this atypical business cycle, interest rates could stay near zero for another year or longer.

2. Steep yield curves often dampen the impact of rising rates on bond yields.

3. Compounding interest income from bonds can produce positive total returns, even if interest rates start rising a year or two from now.

A most unusual cycle

It may seem strange to use the phrase “still too early” when the economy is well into the fifth year of the recovery/expansion phase of the business cycle. If this were a typical cycle, it would now be showing signs of old age. Chart 4 shows that this is not a typical cycle. Growth in real GDP, in the Consumer Price Index (CPI) and other measures of inflation, and in employment has been approximately half the average growth in these indicators over the previous eight cycles. Consequently, signs of old age, or those elements that usually precede the onset of Fed tightening and a cyclical rise in interest rates, are not yet in sight. There are few, if any, capacity constraints; wage pressures are largely absent; unit labor costs are up a modest 1.9% from a year ago; the M2 version of the money supply has increased a moderate 6.5% over the past 12 months; commodity prices are not increasing; and inflation is closer to 1% than 2%.

Chart 4: Growth in measures of output, employment, and consumer prices
has been approximately half the average over the previous eight cycles

*Employment is represented by total nonfarm payrolls. **Average for postwar recessions.
Source: FactSet and authors’ calculations

With inflation this low, the Fed can keep interest rates low much longer than it did in earlier cycles. The federal funds rate has been near zero for five years. That matches the longest previous period—from mid-1989 to mid-1994—in which the Fed kept the federal funds rate at the cyclical low. Yet, Fed officials continue to emphasize that the federal funds rate will likely stay unchanged for an extended period— perhaps until the unemployment rate drops below 6%. A sizable majority of the FOMC expects the federal funds rate to stay unchanged into 2015. In that event, returns from cash and cash equivalents would remain near zero for at least another year.

Implications of steep curves

It has become commonplace to hear predictions of steeply negative returns once the Fed starts pushing short-term rates upward. We would argue that such predictions do not give sufficient weight to the fact that yield curves today are exceptionally steep. The history of previous interest-rate cycles would suggest that, largely because of that extreme steepness, the next cyclical rise in bond yields might not be as severe as many observers are predicting.

Six cycles over the postwar period in which the Fed began tightening had yield curves that were steep. The first was in 1958 and the last was in 2004. In each of those six cycles, the Treasury yield curve was significantly flatter at the end of the Fed tightening cycle than at the beginning. In fact, in most of those cycles, the curve was inverted by the time the Fed stopped tightening. The average 30-year to 2-year slope at the end of Fed tightening was -45 basis points (bps; 100 bps equals 1.00%). (Today, that slope is 330 bps.) Yield increases for the 10-year and longer maturities were, on average, less than one-third the increases in the 2-year yields, and the increases in the 2-year yields were much smaller than the increases in the federal funds rate.

Chart 5 shows how dramatically the Treasury yield curve flattened in the most recent Fed tightening cycle. From mid-2004 to mid-2006, the federal funds rate increased from 1.00% to 5.25%, in 25-bp increments, but bond yields were essentially unchanged during that period. Municipal market yield curves show the same degree of flattening over that cycle. If, in the next episode of Fed tightening, increases in the federal funds rate are as gradual as they were from 2004 to 2006, as Fed Chairman Bernanke has suggested is most likely, yield curves could flatten as dramatically as they did then.

Chart 5: The Treasury yield curve flattened dramatically in the Fed tightening cycle from 6-1-04 through 6-30-06

Source: Bloomberg

The power of compound interest

Table 1 illustrates both the importance of a flattening yield curve and the power of compound interest. It is a widely held assumption that in a period of Fed tightening and rising short-term interest rates, cash and cash equivalents perform much better than notes and bonds that have longer durations. But, that was not true from 2004 to 2006. The superior interest income that steep curves provided in 2004, together with relatively small increases in bond yields, resulted in much greater returns from longerduration portfolios than from cash equivalents. In this analysis, we use Treasury bills to represent cash equivalents. Compounding the incremental interest income over the two-year investment horizon was the key factor contributing to the superior performance of Treasury, corporate, and municipal bonds.

Table 1: In a period of Fed tightening and rising short-term interest rates, longer-duration portfolios delivered greater returns than cash equivalents

Total returns (%), 6-1-04 to 7-1-06
Treasury bills 6.2

Treasury 30-year bonds 10.6

Corporate bonds 10.1

High-yield market 17.6

Municipal bonds, 10+ years 14.6

Source: Bloomberg
Past performance is no guarantee of future results.

To be sure, bond yields were higher in June 2004 than they are now, and those higher yields contributed to the total returns shown in the table. Yields on 10- and 30-year Treasuries were approximately 150 bps higher in 2004, while high-yield corporate yields were 200 bps higher. In contrast, yields on 10-year and 30-year municipal bonds were, respectively, only 70 bps and 40 bps higher in 2004 than today, illustrating just how unusually generous municipal market yields are today.

It is possible to estimate whether today’s lower market yields would substantially change the investment results from those implied by the 2004–2006 experience. We need to make several assumptions about the course of Fed policy and the degree of flattening of yield curves and then have the Bloomberg System calculate total returns over a future investment horizon. If we were to assume that the Fed begins raising the federal funds rate around mid-2015 and the increases are gradual, that rate could be around 3% three years from now.

If yield curves were to flatten gradually as the federal funds rate increased, yields on 10- and 30-year Treasuries would be expected to increase by far less than the federal funds rate. Yields on 10-year investment-grade and high-yield corporates would be expected to increase only moderately from current levels. Because municipal yields are now unusually high versus Treasury yields, those yields are assumed to increase even less than corporate yields.

In this forward-looking scenario, projected cumulative returns remain positive over the three-year investment horizon, as they were from 2004 to 2006. Estimated returns are fairly meager for Treasuries because Treasury yields are now relatively low. In the markets that offer greater interest income, namely high-yield corporates and A/BBB municipals, the projected returns are substantially better than returns from Treasuries. Again, the relatively strong returns from municipal bonds is due to the fact that those yields are now unusually high relative to Treasury and corporate yields and are assumed to move closer to traditional alignment with those taxable sectors over the three-year investment horizon.

It is true that if yields were to rise as assumed here, the prices of the bonds or the net asset values of bond funds would be lower in 2017 than today. Over that investment period, however, the income from the collection and reinvestment of the coupon payments on those bonds is greater than the reductions in prices—hence the positive returns. While these are, admittedly, simulations that could prove to be well off the mark, they stem from conservative assumptions about the future course of short-term rates and bond yields. Most important, they illustrate the benefits of compounding interest income— something that Albert Einstein called the eighth wonder of the world.

What we expect for fixed income in 2014

The consensus forecast from members of the FOMC is that even a gradual rise in the federal funds rate might not begin until 12 to 24 months from now. In that event, the incremental interest income provided by unusually steep curves would likely be the primary component of total returns. Even as short-term rates rise, the compounding of that interest income, together with flattening of yield curves, would, in our view, produce better returns from notes and bonds than the most dire commentaries are now predicting.

Because incremental interest income is the key to better performance in our simulations, our strategic recommendations for the year ahead are focused on the corporate and municipal markets. Among corporates, we believe the BBB-rated and high-yield sectors are expected to perform best. Within high yield, we would significantly underweight the CCC and weaker credits, as those issues have rallied so strongly that we feel they no longer offer sufficient incremental value to offset the greater risk of default.

It would be difficult to overemphasize the attractiveness of municipals today. AAA-rated municipals maturing beyond five years yield more than Treasuries when the long-term averages have the municipal yields around 75% of Treasury yields. Yields on A-rated municipals are now only slightly less than yields on comparable corporates, while the long-term average for the A-rated municipal yields is approximately 80% of corporate yields. By virtually any metric, the municipal market is exceptionally cheap to the taxable markets. And, because quality spreads are unusually wide, the best values within the municipal market are the A/BBB/BB credits. Capturing those values requires the support of good credit research and experienced, professional portfolio managers.


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