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Fixed-Income Insights

Investor fears about the impact of Federal Reserve interest-rate hikes and the liquidity of the bond market may be misplaced. Here's why.

 

In Brief

▪ Bond-market investors are concerned about Federal Reserve interest-rate hikes, and any potential market liquidity problems in the event of a significant sell-off.

▪ But we think their fears are misplaced. This article examines five common misconceptions about the market impact of Fed hikes, the workings of bond-market liquidity, and the size and scope of a potential market sell-off:
Myth No. 1: Fed rate hikes cause all interest rates to rise.
Myth No. 2: All bond investments lose money when interest rates go higher.
Myth No. 3: Fed rate hikes mean that bad market liquidity will get even worse.
Myth No. 4: Poor liquidity means that there will be a dearth of buyers when investors want to sell.
Myth No. 5: The bond market is headed for a collapse thanks to the Fed, poor liquidity, etc.

▪ The key takeaway—Understanding key concepts with regard to the behavior of fixed income securities, the influence of Fed policy on investments, and the value of liquidity, should go long way toward easing the concerns of today's bond investor.

 

Fixed-income investors are concerned, and understandably so, about two pressing issues: the Federal Reserve’s looming “liftoff” of the fed funds rate and the basic ability of the bond market to function in a significant sell-off, especially after a number of articles in the financial press have raised concerns about market liquidity. Many financial commentators have invoked the specter of the 2008–09 bond market rout when describing the potential scope of a likely sell-off later in coming months.

We believe proper context can help ameliorate these concerns. In that spirit, we will examine five common misconceptions about the impact of Fed policy on fixed-income investments, the workings of market liquidity, and the historical differences between today’s bond market and that of 2008–09.

Myth No. 1: “Fed rate hikes cause all interest rates to rise.”
The Fed only controls the fed funds rate—that is, the overnight lending rate between banks for funds held at the Federal Reserve. This has no direct impact on longer-term rates, like those on the five- and 10-year U.S. Treasury notes. In fact, some of the Fed’s extraordinary policy steps over the past several years (a commitment to low interest rates for a long time, and quantitative easing, or QE) were attempts to influence those longer rates, but those programs have long since ended. Changes in longer rates are chiefly influenced by economic growth prospects and inflation expectations; the fed funds rate matters for longer rates only insofar as it impacts those expectations.

As an example of the negligible impact the Fed has on longer rates, consider the last series of Fed hikes in 2004–06. The Fed raised the fed funds rate, from 1% to 1.25%, on June 30, 2004, and proceeded to increase the rate by 25 basis points (bps) at every subsequent meeting for about two years. By June 2006, the fed funds rate had increased to 5.25%, for a total rise of 425 bps. During that time, the yield on the 10-year U.S. Treasury note rose only 52 bps, from 4.70% to 5.22%—merely one-eighth the size of the move in fed funds. Because market expectations of future growth already had been priced in before the hikes, the 10-year Treasury yield moved only a modest amount. A similar relationship is evident in other Fed rate-hike episodes as well (see Table 1).

 

Table 1. 10-Year Treasury Yields Have Risen Far Less Than the Fed Funds Rate During Past Tightening Cycles
Changes in indicated rates during listed periods of Federal Reserve rate hikes

Source: Federal Reserve Bank of New York, The Citigroup 10-Year Treasury Bond Index.

The historical data are for illustrative purposes only, do not represent the performance of any Lord Abbett mutual fund or any particular investment, and are not intended to predict or depict future results. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment. Investors may experience different results. Due to market volatility, the market may not perform in a similar manner in the future. Treasuries are debt securities issued by the U.S. government and secured by its full faith and credit. Income from Treasury securities is exempt from state and local taxes.

Past performance is no guarantee of future results. Please refer to "Important Information" regarding the economic indicator data in these charts and index information. 

 

The most important point to remember now is that the market already expects the Fed will hike rates. That expectation is currently priced into every single bond. The only reason that even short-term rates (which can experience more of an impact from Fed rate moves) could actually go higher is if new information comes into the market suggesting that rate hikes, when they are implemented, will come at a faster pace than previously expected. Conversely, if the central bank indicates that it will hike more slowly than anticipated, expected fed funds and other short-term rates could actually go down. The bottom line is that there is no reason a rate hike or two should send longer-term interest rates sharply higher.

Myth No. 2: “All bonds lose money when interest rates go higher.”
While it is true that bond prices go down when yields go up, that’s only part of the equation. The questions you must ask are: “Which yields are going up?” and “Which particular bonds are we talking about?” Earlier, we showed that not all yields move in the same manner (as illustrated by the fact that the change in short-term rates controlled by the Fed does not always translate to changes in longer-term yields, driven by the market). Along similar lines, it’s important to recognize that not all types of bonds move in tandem, either. Generally, when those in the financial media talk about yields rising, they are talking about U.S. Treasury yields; however, more credit-sensitive segments of the market are influenced by factors beyond movements in the supposedly risk-free Treasury rate. For example, a rising interest-rate environment typically is accompanied by an improving economy. This can be a positive for corporate credit, as stronger growth can lead to lower credit spreads due to improved cash flows and reduced default probabilities. As a result, corporate debt can do well as tighter spreads can help offset higher rates.

It’s also important to note that the return from investing in bonds is a combination of price movement and income. This is why bonds are such a valuable portfolio diversification tool—under normal conditions, a fixed-income security will provide a steady source of income (the scheduled payment of principal and interest is explicitly spelled out in the indenture). Focusing exclusively on rate moves and price changes, which can make more sense for low-yielding Treasuries, ignores the “income” part of fixed-income investing.

Table 2 displays the performance of various fixed-income categories during periods of sharp interest-rate increases. The record shows that credit-sensitive segments of the market have done well even during periods of rising Treasury yields. Why have higher-yielding bonds than Treasuries generated positive returns in each of these periods? The combination of higher income and potentially tightening credit spreads (from an improving credit profile) help offset the headwind of higher Treasury yields. Short-term corporate bonds, historically, also tend to generate positive returns during periods of rising rates. Due to their lower duration, their prices are less sensitive to periods of rising rates, even when shorter rates rise faster than longer rates. When combined with their additional yield over “risk-free” Treasuries, short-term corporates hold appeal for investors looking for an effective portfolio countermeasure when rates rise.

In short, bond returns are driven by more factors than the oversimplified “yields up, prices down” concept. Income is a critical consideration, and it is part of the reason that there are multiple fixed-income asset classes that have, historically, performed well during periods of rising interest rates. Investors who are concerned about the impact of rising Treasury yields may want to consider a flexible and diversified investment approach that emphasizes higher-income, credit-sensitive sectors.

 

Table 2. Credit Historically Has Performed Well When Treasury Yields Rise
Index returns during periods of Treasury yield rising 100 bps or more

Source: Morningstar.
1 Citigroup 10-Year U.S. Treasury Bond Index.
2 Barclays U.S. Aggregate Bond Index.
3 BofA Merrill Lynch 1-3 Year BBB-Rated Corporate Bond Index.
4 BofA Merrill Lynch High Yield Master II Constrained Index.
5 Credit Suisse Leveraged Loan Index.
6 BofA Merrill Lynch All Convertibles, All Qualities Index.
7 S&P 500 Index.

The historical data are for illustrative purposes only, do not represent the performance of any Lord Abbett mutual fund or any particular investment, and are not intended to predict or depict future results. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment. Investors may experience different results. Due to market volatility, the market may not perform in a similar manner in the future. Treasuries are debt securities issued by the U.S. government and secured by its full faith and credit. Income from Treasury securities is exempt from state and local taxes. Floating-rate loans are lower-rated, higher-yielding instruments, which are subject to increased risk of default and can potentially result in loss of principal. Bond prices move inversely to interest rates: when interest rates rise, bond prices fall, and when rates fall, bond prices rise. With floating-rate loans, the opposite is true: loan prices tend to move in the same direction as interest rates; when short-term interest rates rise, loans pay higher income, and they pay less when rates fall. High-yield securities carry increased risks of price volatility, illiquidity, and the possibility of loss in the timely payment of interest and principal. Stock prices fluctuate, sometimes rapidly and dramatically, due to factors affecting individual companies, particular industries or sectors, or general market conditions. Convertible securities have both equity and fixed-income risk characteristics.
Past performance is no guarantee of future results. Please refer to "Important Information" regarding the economic indicator data in these charts and index information.

 

Myth No. 3: “Fed rate hikes mean that bad market liquidity will get even worse.”
As we noted before, there has been a lot of media attention paid to liquidity in the bond market. Some alarmist investors have gone so far as to claim that liquidity has never been worse. We believe that during times of market stress, liquidity has never been particularly good, and we always have managed our portfolios with an eye toward less liquid environments. Said differently, investors often make the mistake of believing that true liquidity, or the ability to buy or sell assets during times of stress, is roughly the same as liquidity in their current environment. It is those periods of complacency, in which liquidity is most frequently mispriced, that concern us the most. The market environment of 2006 and 2007, for example, seemed awash in liquidity that investors took for granted—a notion that was upended by the unpleasant events of 2008–09.

Right now, however, liquidity concerns are receiving significant attention, with myriad warnings of potential impairment. This focus is a healthy sign that the broader financial community is recognizing liquidity as an issue before investors become overly dependent on an ability to buy or sell risk assets that was never going to be there. This is the opposite of what happened in the run-up to the 2008–09 financial crisis. In mid-2015, investors and regulators are recognizing liquidity as an issue well in advance of its potential disappearance, which means, ironically, that it is less likely to be an issue than it would be without the media drama.

One additional point to make here is that the Fed is extremely focused on the stability of the financial system. Policymakers will likely do everything they can to help support and stabilize the fixed-income market, especially as yields slowly return to slightly more normal levels and the Fed tries to wean the market off the extraordinary levels of policy support. The Fed has communicated that it is considering market health as an important factor in its deliberations, so an adverse market reaction to an actual Fed hike likely would result in an even slower pace of hiking, with continued calming and accommodative language. Also, because it has been so many years since an interest-rate hike, it is likely that the Fed will want to pause for some time to assess market health after a few rounds of tightening.

In addition to the Fed closely monitoring liquidity and market health, other financial regulators spend a lot of time talking to key market players—dealers, brokers, asset managers, and the like—and have been focused on liquidity concerns for years, and on any other issues that might impact the market when the Fed hikes. With years of planning under their belts, regulators will likely take steps to make sure the system stays as healthy as possible.

Myth No. 4: “Poor liquidity means that there won’t be enough buyers when investors want to sell.”
This myth confuses two separate issues. First, liquidity is about how easily bonds can transfer from sellers to buyers. It is not about the quantity of buyers and sellers, but rather how bonds change hands from one party to another. That transfer mechanism, however, is unquestionably changing, owing to regulatory changes over the past few years. It means that some of the buffer that smooths market-price action when bonds change hands has been diminished. It also means that price volatility likely will increase as a result.

But change is not necessarily bad; it just means there will be different winners and losers than previously. Winners likely will be able to combine nimble size with a flexible investment platform and process. Wall Street used to get paid for providing liquidity; the market is shifting to compensate others for providing liquidity, and the new winners will be those who can be opportunistic enough to get paid for doing so. The shifts also mean that markets likely will behave differently than they have in prior periods; we have seen signs of this during the past couple of years (as we will discuss below). The upshot is that some investors will struggle with the changing environment and with how to source risk and allocate capital efficiently. While this certainly is a problem for the affected investors, it is not emblematic of a broader market crisis.

The “problem versus crisis” distinction highlights the confusion surrounding the second issue: the idea that “bad” liquidity means investors won’t be able to sell when they need to sell, due to a lack of buyers. The media has given this idea a lot of traction, but misses the point that the Wall Street firms that facilitate the sale process do not ultimately end up owning the bonds, and never have. These entities move the securities from sellers to buyers, and will hold the risk only briefly to facilitate the transaction. To be sure, Wall Street firms historically have acted as a buffer against price volatility, but this role never had anything to do with the question of whether or not there would be buyers. Wall Street has never been willing to buy from sellers without having buyers on the other side. And yet for those concerned about a crisis, the real question is whether there ever will be other buyers, or what will happen if everybody is trying to sell something at the same time. Yet centuries of financial history with a number of market crises have demonstrated that buyers always emerge when asset pricing looks sufficiently attractive. More importantly, this fear has nothing to do with the liquidity concerns that have been spotlighted in the press.

All of this is not to say that we won’t have flare-ups of risk, especially when assets underperform; such is the nature of markets, and corrections can be healthy. Some episodes of poor performance of various asset classes over the past couple of years, fueled by technical factors—such as fund redemptions and the emergence of multiple simultaneous sellers—seem to be characteristic of the changing market environment. Assets will abruptly underperform, and then rapidly bounce back within a month or two. While the market has behaved differently than it has in previous periods while running its course of normal ups and downs, this difference is entirely consistent with changing liquidity dynamics. 

And, as expected, these flare-ups have presented problems for some investors—and opportunities for others. While such episodes serve to illustrate that risk changes hands in different ways than it used to, potentially rewarding balanced and opportunistic approaches, they by no means suggest that there is a broader crisis looming in which there simply are no buyers.

So, will there be buyers in future episodes of market turmoil? Will there be enough money available for investment in the market when it’s really necessary? If anything, the biggest investment problem right now is that there is too much money out there. Many investors at the retail and institutional levels consider themselves underinvested; many asset managers have a lot of money in reserve, waiting for a better opportunity. Perhaps most important, for all the concern about money managers receiving simultaneous redemptions, some context is in order. In the nearly $33 trillion U.S. bond market, there is less than $3 trillion in fixed-income mutual funds. Pensions, insurance companies, and banks, not just in the United States but elsewhere, and starved for yield, would love nothing more than to buy available bonds with higher yields.

Myth No. 5: “The bond market is headed for a collapse thanks to the Fed, poor liquidity, etc.”
Investors well remember the gut-wrenching market moves experienced during the debt crisis that began in 2008. But a quick check of the calendar, and more important, market fundamentals, tells us that this isn’t 2008:

  • The factors that precipitated the 2008–09 crisis, extreme as they were, included: a reversal of a multi-decade debt cycle, systemic leverage, questionable balance sheets for financial institutions, and the prevalence in the market of securities of indeterminable value with horrible underlying fundamentals (primarily certain mortgage-linked derivatives).
  • In 2008, the Fed was playing catch-up, trying to understand the issues as problems kept escalating, while the deleveraging cycle spiraled out of control.
  • In 2008, rapidly deteriorating fundamentals triggered waves of defaults, and poorly underwritten securities, with highly complex structures, were impossible for investors to value. Eventually, even investors in money-good securities (i.e., those instruments that are widely expected to be fully repaid) were forced to sell to meet margin calls as banks called in loans.
  • In 2008, borrowers and lenders were both making decisions based on easy money, an excess of liquidity, and good old-fashioned greed.

Today, the world is awash in unlevered, underinvested cash. Today, the trailing 12-month default rate on U.S. speculative-grade debt is less than half of what it was in 2008, according to Moody’s. Today, we have a battle-hardened Fed that is better prepared for sudden changes in the market, and a healthier financial system with improved regulations. Today, valuations seem driven by an excess of caution, not greed. And perhaps most important, with years of warning about everything from Fed hikes to poor liquidity, investors have had years to prepare. Sure, it might get choppy for a time. But nimble, flexible, and opportunistic investors should be able to take advantage of an increase in volatility. So, while the prospects of a true collapse are quite unlikely, a good investor manager will be prepared—and ready to act no matter how the cycle of Fed hikes plays out.

 

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