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Fixed-Income Insights

What has happened to key fixed-income categories during periods when the Federal Reserve has raised the fed funds rate? Here's a look.

 

In Brief

  • Projections from the Federal Reserve and economic forecasters call for an increase in the benchmark fed funds rate in 2015 or after. Should recent trends in inflation and the labor market continue, the Fed may have reason to move sooner.
  • A look at past periods when the Fed has raised rates shows that the yield spread between two-year and 10-year Treasuries flattened, or even compressed to the point of inversion.
  • However, during these flattening or inverting periods when short-term rates moved substantially more than long-term, shorter-term fixed-income securities performed relatively well.
  • The key takeaway—If and when the Fed decides to begin raising rates again, fixed-income investors may wish to consider issues that are lower in maturity and credit quality.

 

You may have seen a number of recent headlines containing variations of the following phrase: “Rate Hike May Come Sooner Than Expected.” In some corners of the fixed-income market, there are concerns that the Federal Reserve may hike the benchmark fed funds rate by the end of 2014, well ahead of previous expectations and the Fed’s own projections. Such a move could distort values of fixed-income securities and alter the growth trajectory of the U.S. economy for 2015.

In fact, the details below the headline are much less alarming. Some economists have shifted their expectation for a hike in the fed funds rate from early 2016 to late 2015 (Goldman Sachs) or from the fourth quarter of 2015 to the third quarter of 2015 (JP Morgan Chase). The catalyst for this change seemed to be a recent run of stronger than expected data on the labor market and inflation. In June, the U.S. economy added 288,000 jobs, according to the Bureau of Labor Statistics (BLS), with the unemployment rate falling to 6.1%. Meanwhile, the headline consumer price index (CPI) rose to 2.1% for the 12 months ended June, according to the BLS.

Collectively, these numbers seem to justify the potential for an earlier move by the Fed. Even without extrapolating June’s 288,000 jobs numbers, the monthly average for the first half of 2014 is 231,000 compared with an average of 195,000 for the same period in 2013, suggesting some Fed success with their goal of improving job growth. In fact, the 6.1% unemployment rate is what the Fed had targeted for year-end 2014, not midyear. On the inflation front, the headline CPI figure for June is indeed above the Fed’s 2.0% target.

Reacting to Rising Rates
However, the Fed may view the numbers differently. Employment data are regularly revised, and June’s job growth of 288,000 may not be repeated soon. Even a small increase in the historically low labor-force participation rate could allow the 6.1% unemployment rate to increase even with monthly job growth in excess of 200,000. And the Fed’s preferred inflation measure, the core personal consumption expenditures (core PCE) deflator compiled by the Bureau of Economic Analysis, was most recently at 1.5%, well below the central bank’s 2% target.

Nonetheless, even though the numbers may not demand a policy adjustment soon, progress in employment and gradual increases in inflation suggest at some point that rates are likely to rise. Despite the fact that the rate rise may not begin for a year or more, it is not too soon to explore what effect a rate rise will have on different asset classes.

Examining the performance of different fixed-income classes in the three periods during which the Fed raised the fed funds rate over the past 20 years should be instructive. The three periods listed in Table 1 cover rate increases of varying sizes: 300 basis points (bps), 175 bps, and 425 bps. (A basis point is one one-hundredth of a percentage point.)

 

Table 1. A Guide to Recent Rate Hikes—and How the Yield Curve Responds
Change in fed funds rate and the two and 10-year Treasury yield spread for the indicated periods
Source: Federal Reserve and Credit Suisse.
Past performance is no guarantee of future results. 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. Due to market volatility, the market may not perform in a similar manner in the future.
The value of an investment in fixed-income securities will change as interest rates fluctuate and in response to market movements. As interest rates fall, the prices of debt securities tend to rise. As rates rise, prices tend to fall. 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.

 

It is interesting to note that in each tightening period, the yield spread between two-year and 10-year Treasuries flattened, or even compressed to the point of inversion, where short-term Treasuries actually yielded more than long-term government debt. Even more interesting and somewhat counterintuitive is that during these flattening or inverting periods when short rates moved substantially more than longer rates, shorter-term asset classes performed relatively well. As Table 2 illustrates, shorter-maturity indexes generally outperformed their longer-term equivalents. Flattening or inverting yield curve movements have often occurred when the Fed is aggressively tightening policy in order to slow economic growth and reduce inflation. Arguably, the Fed this time is planning on normalizing yields—a much milder process than the aggressive tactics employed to stop inflation and an overheating economy. Accordingly, the Fed does not expect that a return to normal interest rates will involve an inverted curve.

 

Table 2. How Have Key Bond Market Sectors Performed During Rate-Hike Episodes?
Total return by category during indicated periods of Federal Reserve rate hikesSource: Bloomberg, BofA Merrill Lynch, Credit Suisse, and Morningstar.
*2004-2006 indicates three-year average annual returns. 
1 BofA Merrill Lynch U.S. Corporate Master Index.
2 BofA Merrill Lynch High Yield Master II Index.
3 BofA Merrill Lynch U.S. Corporate 1-3 Year Index.
4Credit Suisse Leveraged Loan Index.
Past performance is no guarantee of future results. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment. Due to market volatility, the market may not perform in a similar manner in the future. Index performance during other time periods may differ.

 

Investment Implications
Regardless of the central bank’s current orientation, it is insightful to learn that during periods of aggressive Fed policy designed to slow the economy and reduce inflation, short-term asset classes historically have tended to perform relatively well. If the Fed is more temperate in its moves as it tries to return to normal monetary policy and normal interest rates, short-term asset classes may perform even better should short-term rates not move quite so high and the yield curve does not become significantly flatter (or invert, for that matter).

 

ABOUT THE AUTHOR

RELATED FUND
The Fund seeks to deliver current income and the opportunity for capital appreciation by investing primarily in high yield corporate bonds.
RELATED FUND
The Fund seeks to deliver a high level of current income by investing primarily in a variety of below investment grade loans.

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