Managing Fixed Income

After the U.S. Federal Reserve raised interest rates last December, most observers expected a steady stream of similar moves from the central bank. But spotty economic data at home and uncertainty abroad has put the Fed on a slower, more cautious path to higher rates. The zig-zag has left fixed income investors grappling with how to adjust their portfolios in a changing environment. Emerging markets, duration and high yield are among the ideas discussed by Michael Hyman, head of investment grade portfolio management at Invesco, Mike Collins, senior investment officer at Prudential Fixed Income and Seth Bancroft, a research consultant at NEPC.

Mike Collins: The Fed has been telling us for years now that they're data dependent. The markets are coming to the realization that the data the Fed is looking at happens to be stock prices, bond prices, commodity prices, the Chinese yuan and Chinese reserves, in addition to U.S. economic data. I think that's an important change in the way they're signaling their intentions.

Michael Hyman: I think they want to raise rates, and if you look optically at where Fed funds are versus where core inflation is running and where employment is, then it's probably merited for them to go ahead and do the increase.

Mr. Collins: Inflation and wages are probably right near the top. Janet Yellen is a labor economist and I think she really wants every person in this country to have a well-paid job before she starts taking away the punch bowl. That's one reason the Fed has been very slow to hike; there's still debate out there about how much slack there is in the labor market.

Mr. Hyman: I think a lot of the concerns are just really about global stability. Still, I think that they have a pretty good window and I would be surprised if they didn't take advantage of the window to go ahead and do another 25 [basis-point increase] in mid-to late summer.

Mr. Collins: I don't believe there's a big political influence. Obviously, events such as the Brexit vote could be a factor that keeps the Fed on hold if it's concerned that a potential Brexit might have a negative impact on global markets.

Seth Bancroft: If the market begins to price [in] whoever is going to be elected or seems to be the front-runner, investors may start to make decisions that impact overall financial conditions. I could see the same thing with the Brexit decision but it's hard to really know what's actually going on behind the curtain in terms of political impact on the Fed.

Mr. Bancroft: You've heard more recent language from Fed members that the pace of rate hikes will be lower than what was originally anticipated. Because of this the probability of elevated volatility is higher today given that the progression of rates hikes, in terms of what is priced into Fed futures, has shifted lower. In other words, even if you have a fairly gradual hike in interest rates, if it is above current market expectations, that may lead to greater volatility.

Mr. Hyman: I think if they go ahead and move slightly ahead of expectations, meaning in July, the first reaction certainly would be some form of moderate sell-off and then I think the focus will be really on what the dollar does subsequent to that, and if the dollar does not strengthen too much, I think probably the markets take it in stride and recover.

Mr. Collins: We've actually had a long duration stance in our portfolios (relative to benchmark) for most of this year. A large part of that duration position is in the back-end of the yield curve.

If the Fed insists on hiking rates in an environment where global growth is muted, earnings growth is muted and inflation is tepid, you could see the yield curve continue to flatten. So to some extent we were positioning for that type of market environment.

Mr. Hyman: A flattening in the yield curve is the traditional play when the Fed enters a rate cycle. We're moderately short duration in our funds. I know we've recently taken that stance in the last couple of weeks primarily due to the increased rhetoric with the Fed but also given the overall level of interest rates.

Mr. Bancroft: We would think of it as proceeding on a path toward some neutral interest rate level, which would be defined as a Fed funds rate consistent with output growing as close to the potential rate as possible with low employment and stable inflation.

It has been a moving target since the beginning of time, and it changes with economic conditions, inflation, growth expectations and demographic changes, which I think [are] particularly important in today's market.

The expected output of our country is no longer as high as it has been in the past at least in the short to medium term. So the expectation of how high interest rates can go, the Fed funds rate can go, is very much capped today.

Mr. Collins: The Fed's viewpoint on policy normalization has evolved. They have the long-term Federal funds rate pegged at basically 3% right now after being above 4% just a few years ago.

So they have, in fact, lowered that long-run expectation quite a bit in just a handful of years, and our sense is that they're going to lower it further. We live in a world where potential U.S. GDP is much lower than it's been in the past, partly driven by demographic and productivity trends.

Mr. Collins: Even though baby boomers by number are smaller than the millennials, as a percent of the population at the time they were coming into the labor force, they were much larger. The baby boomers — 10,000 turn age 65 every day — are leaving the labor market at such a rapid rate that even as the millennials trickle in, the labor force is probably growing at less than half a percent right now. It was almost 2½% back in the '70s and early '80s.

That decline is an important shift as a lower rate drags down potential GDP, which is simply the growth rate of the labor force plus the productivity of that labor force. So if the labor force is growing at 0.5% and let's say productivity is 1%, that's a 1½% potential GDP. I think that's the world we're living in right now.

Mr. Hyman: The U.S. is really the only major economy that has a millennial generation and so when you look in terms of global growth, you have even worsening statistics in Europe and in the primary Asian economies of China and Japan.

Mr. Hyman: I think the growth prospects in the U.S. are still pretty reasonable. I don't see in the near term that we might see negative interest rates. My personal view is that it's not a very productive policy. I think it's very negative for bank balance sheets and fighting deflation.

Mr. Bancroft: Yellen has been safe in her comments regarding negative rates. She has said she'll keep it on the table, which I think is the right answer, just given the state of the economy. But the jury's still out on the impact of negative rates, and it certainly hasn't been overly positive. If anything, it's been the opposite, and there's been more hoarding of cash and actually discouraging [of] lending in the banking sector. So I think that would be a last resort for the Fed.

Mr. Hyman: I think if you are truly fearful of rising rates, there's the standard playbook of shortening the duration and any of the strategies that you're involved in. The other approach is more on the security and asset class level. So buying those types of securities that can absorb changes in rates via tightening of their spreads. That would be getting into things like high yield, structured products and potentially intermediate- to short-duration corporate credit.

Mr. Bancroft: I think many of the changes to portfolios [related to rising rates] have been brought up already just in the last three years. You had clients reconsidering their aggregate exposure, their longer-duration exposure, and some moved to absolute return fixed-income funds, for instance. I'm not sure what type of budget clients currently have to reduce their duration exposure without tilting [further] toward credit exposure.

Mr. Collins: Our rates are really high by global standards. The average 10-year yield in Germany and Japan is essentially zero. If you're a global fixed income investor, there are few other choices. There is the possibility that we're sitting here in a year or two and the U.S. Treasury 10-year yield is at 1¼% as opposed to 2¼% or 3%. That is definitely in the realm of possibility and is a very reasonable probability.

Mr. Bancroft: I think you can always make the argument that holding individual bonds in a separate account is better and the reason being that if you do anticipate higher interest rates, a bond portfolio is a great place to make potential adjustments. You can call your manager up and ask them to adjust duration or quality or what have you. That's similar to any type of strategy in that you have more discretion in the assets versus a fund where obviously you can't make that decision.

Mr. Collins: If an investor has a fairly large sum to invest, having a stand-alone fixed income portfolio can make a lot of sense. Investors with smaller-sized portfolios may benefit more from bond funds, which provide the important features of diversification and liquidity.

Mr. Bancroft: We don't typically recommend the laddered approach and that's just because our clients are total return investors. We think of things in a more total return mindset, total portfolio, and when you think about a barbell, you can do it in many different areas within your fixed-income portfolio, whether it's barbelling risk, duration or liquidity.

Because of the demand at the long end for pensions, both U.S. and elsewhere, and insurance companies, and just given the low level of rates globally, there's a ceiling on how high rates can go. There's a demand force at the end of the curve that prevents it from being overly volatile.

And I think pairing that with a highly liquid shorter-term instrument with less interest rate sensitivity — it just provides a high level of liquidity in a market where there aren't that many great opportunities. So if you do have a dislocation, it can be a source of liquidity to allocate to some attractive opportunities.

You don't have to dedicate that much capital to it given that, on a duration basis, it takes much less capital to fund the long end and get the equivalent defensive benefit that you'd get owning, say, core bonds.

Mr. Bancroft: At one end of the liquidity spectrum, you have the most liquid securities, which are Treasuries — U.S. Treasuries — and high quality shorter-duration corporates as well that are fairly liquid with a lot of buyers in the market.

So pair that with return-seeking credit hedge funds, direct lending-type structures in the U.S. and Europe, and structured products where you earn a high level of current income. In some of these areas there's high credit risk but not as much mark-to-market volatility that you'd get with, say, a liquid high-yield strategy.

Mr. Collins: We manage a number of short-duration corporate and short-duration high-yield portfolios that invest between one and five or six years out on the curve and are effectively large, diversified laddered portfolios. The nice thing about these portfolios is they are self-liquidating. Liquidity is definitely a challenge in today's market.

Generating cash by selling bonds, especially if you happen to be in a tough period like we were in mid-February, can be pretty costly. Having liquidity generated automatically on a regular basis by having bonds roll off and mature, or get tendered and called, and allowing the reinvestment of those proceeds is an attractive feature in this environment.

Mr. Hyman: I think what we like to do within our portfolios is, particularly as it relates to the evaluation of corporate credit, not to be wed to either a laddering or a barbell. We're more intent on valuations and what the shape is of credit curves as it relates to interest rates.

We try to buy bonds where the drop in credit spreads is most acute so that as these bonds roll down the curve, we can pick up both the spread compression and the carry, and then if there's interest rate sensitivity as it relates to where you are on the curve.

Mr. Collins: Even if you believe rates are going up, most investors can benefit by having a reasonable percentage of their portfolio in longer-duration, high quality bonds. Historically, this sector has been one of the few that has been able to offset the drawdowns from equity market weakness.

Mr. Hyman: The first quarter has been a great example. [There was a severe drop in equities] in the first quarter when they were down 10% to 12% but core bond funds were generally up a percent to a percent and a half during the same period of time. That diversification really played out very well in that environment. Now that equities have recouped, interest rates have stayed low and spreads have compressed, your core funds have still delivered very good returns of approximately 4% on the year.

Mr. Bancroft: Remain liquid and balanced. Provide liquidity where you can, balance on a risk basis, and when this does occur, when you do have that hike in rates and depending on how the market reacts, you may be able to allocate capital to something that's more attractive.

Mr. Bancroft: The obvious answer would be [Treasury Inflation-Protected Securities]. TIPS are government-guaranteed so they have a defensive nature. If you look at how inflation is pricing, granted they are a little bit less attractive today, you have the potential for an upside surprise in inflation. In holding TIPS you could capture that.

Mr. Collins: If oil prices keep rising — as they have been lately — other commodities should follow suit, which could lead to higher headline inflation. We are already seeing core CPI above 2%. Companies in the commodity sector are highly levered to commodity prices. That's one area that's been beaten up but will presumably provide some upside if commodity prices increase.

Mr. Hyman: The tech and pharma sectors would also do better [from higher prices]. I think it would potentially be a little bit more challenging for more wage-sensitive industries.

Mr. Hyman: I think the best approach is a multisector, fixed-income portfolio that focuses specifically on credit. Everyone is coming to the U.S. to seek income. I think the expectation of earning 4%, maybe with some appreciation, is going to probably be perceived as pretty good income given the type of market that we're in.

Mr. Bancroft: There's certainly some private lenders in Europe — the type of strategies that have a fairly attractive yield relative to their counterparts in the U.S., but that's somewhat niche and not necessarily scalable. So there's not a whole lot but certainly opportunities here and there.

Mr. Bancroft: Emerging markets are yielding 7[%]-plus. Granted, there is certainly some energy and commodity sensitivity, but emerging market debt looks fairly attractive. I think it's something that is potentially going to experience some bouts of volatility but there certainly is a higher return potential than in a lot of other areas in fixed income. We've been more proponents of a diversified mix of emerging markets.

Mr. Collins: Within emerging markets debt, there are really three distinct sectors: traditional hard currency bonds, meaning mostly dollar-denominated emerging market bonds; local currency emerging market bonds, where, for example, you can buy a 10-year Brazilian real-denominated bond at close to a 13% yield, but you own the currency, as well; and emerging market corporate bonds, of which many happen to be dollar-denominated.

Some of the emerging market debt strategies that we talk to clients about are blended portfolios that have exposure to all of these different categories. An active manager can then rotate among those sectors and select the most attractive underlying securities within each category. We believe that's a really effective approach to managing emerging market debt.