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Fixed-Income Insights

With the U.S. Federal Reserve poised to dominate the financial headlines in 2015, which segments of the fixed-income market might be most attractive?

 

In Brief

  • What can U.S. fixed-income investors expect as 2015 unfolds? Let’s look at two key areas of concern:

  • 1) U.S. economy—Jobs growth, and improvements in commercial and consumer lending, signal that U.S. economic growth is improving and potentially self-sustaining.

    2) Fed policy—While the median projection from U.S. Federal Reserve policymakers calls for the fed funds rate to increase to 1.13% by the end of 2015, a cumulative rate rise of 0.50% to 0.75% seems more appropriate, and more likely.

  • The key takeaway—Within fixed income, convertible securities, high yield, and the lower tiers of investment-grade debt seem positioned to perform better than lower-coupon, interest rate-sensitive, high-quality securities.

 

In looking toward the prospects for markets and the economy in 2015, one cannot help but focus squarely on the U.S. Federal Reserve and its efforts to bring interest rates toward “normal” levels. Persistent jobs growth, increased bank lending, and the consumption-friendly benefits of a stronger dollar and lower oil prices create an environment ideal for the Fed to begin adjusting monetary policy toward normal interest rates.

The Fed’s moves toward this goal seem likely to be restrained by low inflation, a fear of handicapping U.S. expansion, and slow global growth. A rise in longer-term interest rates also could be restrained by low inflation and low rates on comparable maturities of government bonds in Europe and Japan.

Even if interest rates were to rise only a portion of what the Fed expects, yields on high-quality, interest rate-sensitive debt will be affected more than those of lower-quality, economically sensitive securities. In a world starved for economic growth, yield, and currency security, U.S. investments seem positioned to benefit. Within fixed income, convertible bonds, high yield, and the lower tiers of investment-grade debt should perform better than lower coupon, interest rate-sensitive high-quality securities.

Let’s take a closer look at what investors may expect as 2015 unfolds.

Economic Background
Jobs growth, and the level of commercial and consumer lending, have been Fed focal points for indications that U.S. economic growth is improving and potentially self-sustaining. The 2014 nonfarm payrolls numbers from the Bureau of Labor Statistics suggest the Fed’s patience has been rewarded.  Jobs growth has averaged more than 240,000 per month for the first 11 months of the year, compared with monthly averages of 194,000 and 186,000 for 2013 and 2012, respectively. Although many jobs are temporary or low paying, improvement has been made in the number of higher-paying jobs, including manufacturing and business and professional positions. Toward the end of the year, slight increases in compensation also have surfaced. 

In terms of lending, increases are evident among all key categories. According to the Fed, commercial and industrial loans through November grew at a 12% pace in 2014, compared with about 7% in 2013. Consumer loans were up at a 5% rate versus 3.5% in 2013. And real estate lending finally turned positive after several years of contraction.

In addition to the labor market and loan-growth indicators, lower oil prices and dollar strength should support U.S. growth. Cheaper oil frees consumer funds previously spent on gasoline and home heating fuel. Similar benefits accrue to companies that now can enjoy reduced transportation costs (shipping), fuel costs (especially manufacturers), and reduced packaging costs (plastics). A stronger dollar reduces the cost of imports, expanding consumer purchasing power and reducing cost of goods to business and manufacturers. Lower oil and a stronger currency, while not beneficial to all sectors of the economy, effectively act for most consumers and businesses as the kind of tax breaks that Congress would find difficult to achieve.

Fed Policy
Where does this all leave the U.S. central bank? The economic conditions we’ve discussed here seem to empower the Fed to start raising interest rates by mid- 2015. However, policymakers’ median “dot-plot” expectation of a 1.13% fed funds rate by year-end 2015 seems aggressive for several reasons. First, a historically minded central bank’s primary concern with rate hikes is to avoid a repeat of the 1937 crisis in which higher rates pushed the economy back into recession. This primary risk, combined with a more dovish Federal Open Market Committee after the departure of two policy hawks—Richard Fisher, president of the Dallas Federal Reserve Bank, and Philadelphia Fed president Charles Plosser—should produce a more cautious approach than Fed projections imply. Second, the inflation dampening effects of lower oil and a stronger dollar (namely, lower-priced imports) should allow a dovish Fed more leeway in its rate agenda if economic growth slows in response to early rate hikes.  

Third, there are other influences that could compromise U.S. growth. Recession in Japan and slow growth in the eurozone could affect U.S. exports as well as profitability of companies with non-U.S. exposure. The competitiveness of U.S. exporters also is hurt by the devaluations of other currencies versus the dollar. To the extent U.S. exporters respond by reducing production or moving it overseas, U.S. growth will be affected. Similarly, while lower oil helps many companies, for the U.S. energy industry it will compromise profitability, capital investment, and potentially production. Taken together, these issues could be sufficient enough to dull the edge of U.S. expansion to the point where a slower rate rise becomes appropriate policy.

The threat of slow global growth, the impact of a stronger dollar on U.S. exporters, and the effect of lower-priced oil on the domestic energy industry suggest that U.S. growth may be unable to withstand a quick rate rise to 1.13% by year-end 2015. A cumulative rate rise of 0.50% to 0.75% seems more appropriate, and more likely, owing to the increasing dovishness on the part of policymakers.

Investment Consequences
How could these developments influence the performance of fixed-income portfolios in 2015? Even if the Fed were able to raise rates only to 0.50% or 0.75%, high-quality, interest rate-sensitive debt will be affected more than lower-quality economically sensitive securities. Once the Fed begins its rate-adjustment process, investors are likely to anticipate future moves, pushing yields higher ahead of the Fed’s action. Rates on longer-maturity, high-quality debt will not be immune, but with Japan and the eurozone teetering on the brink of recession, a yield above 3% on the 10-year U.S. Treasury note seems difficult to achieve. 

Currency devaluation, pursued aggressively in Japan, seems likely to spread to the eurozone and China to avoid economic disaster in those export-sensitive economies. The resulting strength in the U.S. dollar will continue to attract foreign investment. Fed rate moves will make short-term fixed-income investments even more attractive. 

Collectively, in a world starved for reliable growth, relatively attractive yield and stability of currency, the United States, in 2015, appears to offer an array of attractive investment options. Within fixed income, convertible securities, high yield, and the lower tiers of investment-grade debt seem positioned to perform better than lower-coupon, interest rate-sensitive, high-quality securities. The widening of yield spreads on lower-quality debt toward the end of 2014 should allow a more attractive income stream than higher-quality issues, as well as an opportunity for an eventual narrowing of the spread that has historically characterized U.S. rising interest-rate environment. 

Non-U.S. debt will offer selective opportunity, but total returns will be compromised if securities involve depreciating currencies. Generally, U.S. dollar-denominated foreign debt seems to be a better alternative, subject to the ability for companies and governments to repay their obligations should the dollar continue to appreciate. Professional security selection will be an important contributor to total return of non-U.S. debt portfolios. This is especially true of emerging markets, where declining commodity prices affect economic fortunes unevenly. Importers of oil, for instance, offer better prospects than countries reliant on oil as their main export.

How, then, should investors position their fixed-income portfolios in the new year? They may wish to consider securities that offer higher income, and are sensitive to economic conditions rather than interest-rate moves. Conservative investors may want to focus their exposure within the United States and toward higher-income alternatives with less-volatile, shorter maturities.

Fixed-income opportunities outside the United States seem poised to diverge based on the country-by-country effects of low commodity prices, relative currency movements, and the effects of rising U.S. interest rates. Security selection based on analysis of these variables seems a more appropriate strategy for 2015 than adjusting blanket exposure based on geographic region or degree of economic development. 

The Fed will play an important role in the future of different fixed-income asset classes, but we believe the U.S. central bank will not be as aggressive as its forecasts imply. The Fed’s actions, and the performance of many fixed-income investments, will be driven by the consequences of lower oil, dollar appreciation, and persistent but unexciting economic growth.

 

A Note about Risk: The value of investments in fixed-income securities will change as interest rates fluctuate and in response to market movements. Generally, when interest rates rise, the prices of debt securities fall, and when interest rates fall, prices generally rise. Bonds may also be subject to other types of risk, such as call, credit, liquidity, interest-rate, and general market risks. High-yield securities, sometimes called junk bonds, carry increased risks of price volatility, illiquidity, and the possibility of default in the timely payment of interest and principal. Moreover, the specific collateral used to secure a loan may decline in value or become illiquid, which would adversely affect the loan’s value. Longer-term debt securities are usually more sensitive to interest-rate changes; the longer the maturity of a security, the greater the effect a change in interest rates is likely to have on its price. Lower-rated bonds may be subject to greater risk than higher-rated bonds. Foreign investments generally pose greater risks than domestic investments, including greater price fluctuations and higher transaction costs. Special risks are inherent in international investing, including those related to currency fluctuations and foreign, political, and economic events. Further, investing in the securities of issuers located in certain emerging countries may present a greater risk of loss resulting from problems in security registration and custody or substantial economic or political disruptions. No investing strategy can overcome all market volatility or guarantee future results.

Forecasts and projections are based on current market conditions and are subject to change without notice. Projections should not be considered a guarantee.

Statements concerning financial market trends are based on current market conditions, which will fluctuate. There is no guarantee that markets will perform in a similar manner under similar conditions in the future.

The fed funds rate is the interest rate at which a depository institution lends immediately available funds (balances at the Federal Reserve) to another depository institution overnight.

Gross domestic product (GDP) is the monetary value of all the finished goods and services produced within a country's borders in a specific time period, though GDP is usually calculated on an annual basis. It includes all of private and public consumption, government outlays, investments and exports less imports that occur within a defined territory.  

Yield is the annual interest received from a bond and is typically expressed as a percentage of the bond's market price.

The credit quality of the securities in a portfolio is assigned by a nationally recognized statistical rating organization (NRSRO), such as Standard & Poor’s, Moody’s, or Fitch, as an indication of an issuer’s creditworthiness.  Ratings range from ‘AAA’ (highest) to ‘D’ (lowest).  Bonds rated ‘BBB’ or above are considered investment grade.  Credit ratings ‘BB’ and below are lower-rated securities (junk bonds).  High-yielding, non-investment-grade bonds (junk bonds) involve higher risks than investment-grade bonds.  Adverse conditions may affect the issuer’s ability to pay interest and principal on these securities. 

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