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Fixed-Income Insights

Here’s how key fixed-income categories might fare should interest rates move closer to historical averages. 

 

In Brief

  • Less accommodative Federal Reserve policy and prospects for a hike in the fed funds rate may presage a return to “normal” (closer to historical averages) interest rates in coming years.
  • Based on Fed forecasts and historical relationships among interest rates, the “normal” fed funds rate would be 4% and the yield on the 10-year U.S. Treasury note could be 5%. 
  • Based on return projections for three- and six-year periods, the ultimate effect of normalization on fixed-income performance would depend on the length of time it takes.  
  • The key takeaway: Whether interest rates return to normal in three or six years, credit-sensitive and short-duration securities seem likely to outperform higher-quality, longer-duration securities in both scenarios.

 

The unwinding of the Federal Reserve’s quantitative easing program, combined with a shift in rate-hike forecasts in March 2014 among members of the Fed’s policy-setting arm, the Federal Open Market Committee (FOMC), seems to assure a return to higher interest rates at “normal” levels. Clearly, the timing of when interest rates move back up to levels in line with historical averages is difficult to call. Many investors expected that the yield on the benchmark 10-year Treasury note would already have moved above 3%, given several consecutive tapering decisions since January 1, 2014. And the Fed itself is unsure when it will hike short-term interest rates, although “mid-2015” seems to cover most FOMC members’ expectations.  

But if the exact timing of such a move is difficult to anticipate, the signs are fairly clear that there will be a move higher in interest rates in the months and years to come. If that is the case, bond strategies can be designed to address the longer-term direction of rates rather than the less-certain question of when they will get there. If we are heading from the abnormal environment of zero interest rate policy, quantitative easing, and unusually low inflation to a more normal economy and monetary policy, what can we expect of interest rates? What is “normal” when it comes to the level of the fed funds rate, the 10-year U.S. Treasury yield, and the spread between the two? 

Since the Fed began releasing longer-term economic projections in January 2012, the longer-term forecast for fed funds by FOMC participants has been about 4%. This consensus forecast was reiterated most recently in the minutes of the FOMC meeting on March 18–19 (released in April 2014). In addition, former Fed chairman Ben Bernanke had previously referred to 4% as the long-term normal level of fed funds, notably in his September 18, 2013, press conference, in which he suggested that target might be reached in 2018 or 2019. And the Taylor Rule (an interest rate forecasting model invented in 1992 by economist John Taylor) also suggests that with the inflation rate remaining near the Fed’s target of 2%, a real (inflation-adjusted) fed funds level of 2–2.5%, and U.S. economic output at its potential, the nominal fed funds rate should be 4–4.5%.   

Approaching Normal
So, if the fed funds rate over the longer term returns to 4%, what should the 10-year Treasury yield be?  Using Federal Reserve data since mid-1954 (when monthly historical data became first available for both the 10-year note and the fed funds rate), the average spread between the two is 102 basis points (bps). This suggests the “normal” yield on the 10-year Treasury may be about 5% (4% fed funds + 100 bps historical spread). Looking more closely at the data reveals that in the decades of the 1960s, 1970s, and 1980s, the spread averaged 40–60 bps, whereas the 1990s and the first decade of the millennium averaged about 150 bps. Presuming that the last 20 years or so is more relevant to this analysis than the preceding three decades, the normal 10-year Treasury yield may be 5.5% (4% fed funds + 150 basis-point spread). So a range of 5–5.5% seems at least realistic for the 10-year Treasury, in the context of our analysis so far.   

Another historical benchmark for determining the 10-year Treasury yield is nominal GDP, which is unadjusted for inflation. Chart 1 suggests that over long periods of time, the 10-year Treasury yield tracks nominal gross domestic product (GDP). If this relationship holds, and the Fed hopes to achieve 2% inflation and 3% GDP growth, the resulting 5% nominal GDP suggests that the 10-year Treasury should yield about 5%, consistent with the level suggested by our earlier example, which combined a historical yield curve and the Fed’s projected fed funds rate of 4%.

 

Chart 1. Treasury Yields Historically Have Tracked GDP before Inflation
Yield on the 10-year U.S. Treasury note versus nominal GDP, 1953–2014

Source: Federal Reserve Bank of St. Louis. Data as of May 6, 2014.
Past performance is no guarantee of future results.
For illustrative purposes only and does not reflect the performance of any Lord Abbett mutual fund or any particular investment.

 

While this seems to legitimize a 5% target for the 10-year Treasury yield, it is important to note that using the long-term relationship between nominal GDP and the 10-year Treasury yield can be misleading over the short run. The often large gaps between the 10-year Treasury yield and nominal GDP in the chart above illustrate the disparities between the two numbers and suggests that conclusions drawn with 50 years of numbers may not be applicable to shorter time frames.

Even with these shortcomings, it seems that based on FOMC expectations, Fed commentary, and the Taylor Rule, a 4% fed funds rate is a good place to target for a return to “normal” and a 5% yield is not unreasonable for a “normal” target for the 10-year Treasury.

Two Scenarios
If a fed funds rate of 4% and 10-year Treasury yield of 5% are reasonable, how long will it take to reach those levels? A most aggressive scenario might assume that the Fed finishes its quantitative easing program before October 2014 and that faster GDP growth allows the central bank to hike rates rapidly early in 2015, pushing the fed funds rate to 2% by year-end 2015 and to 4% by the second quarter of 2017 (three years from now). Consistent with this aggressive and seemingly unlikely scenario, we assume that the 10-year Treasury and the yield of the Barclays U.S. Aggregate Bond Index1 (a widely used proxy for the “core” fixed-income strategy [high-quality government and corporate securities]) will rise gradually in yield from their current levels, to 5%, over the same three-year period. 

We further assume that high-yield securities and bank loans are compromised by both a return to higher normal default rates and a return to wider normal yield spreads. Neither of these assumptions, however, seems rational because in rising rate environments, credit spreads tend to narrow, not widen, and the economic growth that allows the Fed to tighten aggressively should improve the health of lower-quality companies, potentially reducing the likelihood of defaults, not increasing it.

Nonetheless, in the spirit of a conservative approach as well as assuming a return to “normal,” these assumptions were imposed on the calculations below. As Table 1 demonstrates, even with these assumptions, the representative credit-intensive High Yield and Bank Loans indexes outperform the higher credit-quality Barclays U.S. Aggregate and 10-year Treasury indexes over this short time frame. A grouping of shorter-duration fixed-income securities of various types also performs well under this scenario.

 

Table 1. Normalization: The Three-Year Scenario
Projected returns of select investments as yields normalize and yield spreads, default rates, and recovery rates return to historic averages

Source: Barclays, Bloomberg, Credit Suisse, and Lord Abbett.
Forecasts and projections are based on current market conditions and are subject to change without notice. Projections should not be considered a guarantee.
For illustrative purposes only and does not reflect the performance of any Lord Abbett mutual fund or any particular investment.
Indexes are unmanaged and are not available for direct investment.

 

A more realistic scenario would be a longer time frame than three years, especially since recent interest-rate forecasts by FOMC participants place the fed funds rate at about 1% by year-end 2015 and 2.25% by year-end 2016. Using Ben Bernanke’s earlier projection of returning to a normal fed funds rate in 2018 or 2019, and adjusting for the Fed’s historical optimism in economic projections, suggests that a six-year normalization horizon ending in 2020 is worthy of consideration. In Table 2, we show the results for the six-year scenario, including a return to normal credit spreads, normal default rates, and normal recovery rates. Compounding of interest, at higher levels as rates gradually rise, allows positive returns for all the indexes listed. Once again, however, credit-sensitive and short-duration indexes perform better than more interest-rate sensitive, higher-quality indexes, as they reflect the effect of higher interest rates compounding over time and lower rate sensitivity, respectively.

 

Table 2. Normalization: The Six-Year Scenario
Projected returns of select investments as yields normalize and yield spreads, default rates, and recovery rates return to historic averages

Source: Barclays, Bloomberg, Credit Suisse, and Lord Abbett.
Forecasts and projections are based on current market conditions and are subject to change without notice. Projections should not be considered a guarantee.
For illustrative purposes only and does not reflect the performance of any Lord Abbett mutual fund or any particular investment.
Indexes are unmanaged and are not available for direct investment.

 

Investment Implications
Forecasting interest rates, though, can be a fool’s errand. But using Fed forecasts and historical metrics suggests that investors should at least consider a plausible forecast of a return to higher, normal interest rates. If normal is close to a fed funds rate of 4% and a 10-year Treasury yield of 5%, whether we achieve those levels over three years or six years, credit-sensitive and short-duration securities seem likely to outperform higher-quality, longer-duration securities.

 

1The Barclays U.S. Aggregate Bond Index is an unmanaged index composed of securities from the Barclays Government/Corporate Bond Index, Mortgage-Backed Securities Index, and the Asset-Backed Securities Index. Yield normalization assumes the Index yield gradually rises from 2.4% to 5.0% over three years in Table 1 and six years in Table 2.
2This index represents a theoretical rolling 10-year U.S. Treasury note, renewed semiannually to a new higher coupon as rates gradually rise from 2.7% to 5.0% over three years in Table 1 and six years in Table 2.
3The BofA Merrill Lynch High Yield Constrained Index is an unmanaged index comprised of publicly placed, nonconvertible, coupon-bearing domestic debt. Issues in the index are less than investment grade as rated by Standard & Poor’s or Moody’s, and must not be in default. Issues have a term to maturity of at least one year.  Yield normalization assumes the Index yield gradually rises 420 bps from 5.6% to 9.8% over three years in Table 1 and six years in Table 2, reflecting the 260 bps adjustment of the Barclays Aggregate plus 160 bps as today’s high yield spreads return to their historical average.
4The Credit Suisse Leveraged Loan Index is designed to mirror the investable universe of the U.S. dollar-denominated leveraged loan market. The CS Leveraged Loan Index is an unmanaged, trader-priced index that tracks leveraged loans. The CS Leveraged Loan Index, which includes reinvested dividends, has been taken from published sources.  Yield normalization assumes a rise in the Index yield from 4.6% to 7.6% over three years in Table 1 and six years in Table 2, consistent with a rise in Fed Funds and T-Bills of 400 bps and a 100 bps delay to account for the 1.0% floor on most loans.
5The Short Duration Multi-Asset Index is a combination of 40% BofA Merrill Lynch 1-5 year BBB US Fixed Rate CMBS Index, 30% BofA Merrill Lynch 1-5 year BBB US Corporate + Yankee Index, 15% BofA Merrill Lynch US Floating Rate Asset Backed Securities Index, 10% BofA Merrill Lynch 1-5 year B US Cash Pay High Yield Constrained Index and 5% BofA Merrill Lynch CCC + Lower Cash Pay High Yield Index.  Yield normalization assumes a 400 bps rise in the yield of the index to 7.0% consistent with a 4% rise in fed funds, and a change in the default and recovery rates over three years in Table 1 and six years in Table 2 from 0.7% defaults with 41% recovery to 3.9% defaults with 53% recovery.
6Assumed duration multiplied by difference between starting yield and normalized yield.
7Assumes spread widening of 160 bps for High Yield, relative to a representative Treasury benchmark.
8Assumes a change in the default and recovery rates for high yield from 0.7% defaults with 41% recovery to 3.0% defaults with 53% recovery and for Leveraged Loans from 1.8% defaults with 68.6% recovery to 3.5% defaults with 68.8% recovery over three years in Table 1 and six years in Table 2.
9Semiannually compounded return based on gradual rise to normalized yield over three years in Table 1 and six years in Table 2.
10Represents the aggregate amount that an investment has gained or lost over time, independent of the period of time involved.

 

ABOUT THE AUTHOR

RELATED FUND
The Fund seeks to deliver a high level of current income consistent with the preservation of capital by investing primarily in a variety of short duration investment grade and high yield debt securities, U.S. government securities, and mortgage- and other asset-backed debt securities.
RELATED FUND
The Fund seeks to deliver current income and the opportunity for capital appreciation by investing primarily in high yield corporate bonds.

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