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Fixed-Income Insights

Here we examine how U.S. fixed-income categories could potentially respond to two rate-hike outcomes from the Federal Reserve.

 

In Brief

  • Investors may wish to examine two alternative policy paths from the Federal Reserve that could frame expectations for different U.S. fixed-income sectors over the next three years.
  • Scenario One: Based on the Fed’s own projections, released September 17, 2014, the fed funds target rate rises to 3.75% by the end of 2017.
  • Scenario Two: Based on fed funds futures, market expectations suggest that the rate of increase could be much slower as the Fed confronts a weakened economy.
  • The key takeaway—Under both scenarios, shorter-duration, lower-quality securities likely would outperform longer-duration, high-quality debt.

 

If Federal Reserve chairwoman Janet Yellen didn’t sound particularly hawkish at the September 17th press conference that followed the Fed’s two-day policy meeting, the new “dot-plot” projections by other Fed members seemed to indicate that such a view is still present at the central bank. (See Chart 1.) These projections suggest that the benchmark fed funds rate will reach a new “normal” level of 3.75% by the end of 2017, even if U.S. gross domestic product (GDP) does not reach 3%.

 

Chart 1. The "Dot-Plot" Shows the Path to Interest Rate Hikes
Federal Open Market Committee participants’ assessment of appropriate fed funds rate, 2014–onward, as of September 17, 2014

Source: Federal Reserve. Each shaded circle indicates the value, rounded to the nearest one-quarter percentage point, of an individual participant’s view.
Forecasts and projections are based on current market conditions and are subject to change without notice. Projections should not be considered a guarantee.

 

Such aggressive monetary policy has consequences for all investments, but particularly for fixed-income portfolios. Here, we’ll examine the potential impact on key fixed-income classes of a return to “normal” interest rates as implied by the September “dot-plot” projections. We’ll also look at what could happen under a more conservative rate scenario, reflecting investor expectations implied by fed funds futures.

Baseline Scenario: Fed Projections
In an odd interpretation of the “data-dependent” policy approach espoused by the Fed, projections released along with the September 17th Federal Open Market Committee statement called for slower economic growth—and yet, a faster rise in the fed funds rate—over the next three years. The median of the September dot-plot projections for the fed funds rate is 1.38% by year-end 2015, 2.88% by year-end 2016, and 3.75% by year-end 2017. The long-term “normal” rate of the fed funds rate was also projected at 3.75%. 

How could that affect fixed-income investments? If the yield curve “normalizes” by the end of 2017, the historical spread of 100 basis points (bps) between the fed funds rate and the 10-year Treasury yield would place the 10-year yield at about 4.75%. This is consistent with a historical long-term relationship of the yield on the 10-year U.S. Treasury note close to the level of real (inflation-adjusted) GDP plus inflation. The possibility of real GDP of 2.75% plus inflation of 2.0% by year-end 2017 lends credibility to a 4.75% 10-year Treasury yield at year-end 2017. Thus, over the next three years or so, if the Fed succeeds in normalizing rates, and the rate structure, a reasonable expectation may be for fed funds to rise to 3.75%, while the yield on the 10-year Treasury would increase to 4.75%.

The impact of such rate “normalization” on several key asset classes is portrayed in Table 1. The “Fed Projections” scenario analyzes performance over three years beginning December 31, 2014, starting with yields on various indexes as they were on September 30, 2014. The scenario assumes fed funds rate rises to 1.38%, 2.78%, and 3.75% by year-end 2015, 2016, and 2017, respectively, according to the Fed’s most recent median expectations. The yield on the 10-year Treasury is assumed to gradually climb to 4.75% by year-end 2017, where it would be 100 bps above the fed funds rate. The analysis assumes that the two-year Treasury note and a representative one- to three-year corporate bond index move 375 bps higher between year-end 2014 and year-end 2017, the same as fed funds. The yield on the Barclays Aggregate, a broad fixed-income benchmark, and a representative high-yield index are assumed to adjust higher—less than fed funds, but more than the 226 basis-point movement in 10-year Treasuries.

Even though the yield curve flattens under this scenario, and the 10-year Treasury yield rises much less (226 bps) than the two-year Treasury yield (375 bps), the rate sensitivity or duration of the 10-year Treasury impairs performance visibly. Under this scenario, the negative return of 8.12% on the 10-year Treasury is much worse than the return of -0.64% for the two-year Treasury. On the other hand, the higher income associated with a one- to three-year corporate index or a high-yield index allows more favorable returns. The high-yield/low-duration characteristics of the one- to three-year corporate index provide a comparatively favorable return of 3.17%, even though the yield adjusts 375 bps from 2.95% to 6.70% during the time period. 

Returns of a high-yield index also compare favorably. In this case, we assume the 450 basis-point spread between the High Yield Index and the five-year U.S. Treasury note on September 20, 2014, remains the same at the end of 2017. If the five-year Treasury adjusts to 4.50% at year-end 2017, the High Yield Index would adjust to 9.00%. In fact, high-yield returns could be even more attractive if the analysis reflected the historical narrowing in spreads that has taken place consistently over the past 20 years when rates have risen, as we have previously noted. Even without the benefit of narrowing yield spreads, the High Yield Index provides relatively attractive cumulative return of more than 9% in this rather adverse rising rate environment.

 

Table 1.  Performance of Key Fixed-Income Categories Under a “Fed Expectations” Scenario

Source: Barclays, Bloomberg, and Lord Abbett.  The scenario detailed in Table 1 analyzes performance over three years beginning December 31, 2014, with yields on indicated asset classes starting at the same level as they were on September 30, 2014.  The scenario in Table 1 assumes the fed funds rate rises to 1.38%, 2.78%, and 3.75% by year-end 2015, 2016, and 2017, respectively, in line with projections published by the Federal Reserve on September 17, 2014.  The yield on 10-year U.S. Treasury notes gradually moves to 4.75% by year-end 2017.  The yield on both two-year U.S. Treasury notes and the Corporate BBB 1-3 year Index moves 375 basis points (bps) higher by 2017, the same as fed funds.  The yield on the Barclays Aggregate adjusts 239 bps higher.  The High Yield Index adjusts 274 bps, to 9.00%, by year-end 2017, maintaining the September 30, 2014, spread of 450 bps above underlying five-year Treasuries.
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 Scenario for Skeptics
If investor expectations are properly reflected in the fed funds futures market, consensus in early October 2014 anticipates a slower rate rise than the Fed projects. It could be that investors discount a less robust economy than the Fed expects—an economy that may be hamstrung by the interest-rate increases projected by the Fed on September 17. CME futures (as of October 6, 2014) implied a fed funds rate of 0.75% at year-end 2015 and 1.75% at year-end 2016, far short of the respective 1.38% and 2.88% levels implied by the dot-plots. A similarly skeptical level for year-end 2017 of 2.75% is used in this scenario instead of the Fed’s 3.75% forecast. Under this slower rising rate scenario, the 10-year Treasury yield is assumed to gradually rise to 3.75% by year-end 2017, consistent with a 100 basis-point spread to a 2.75% fed funds rate at the time.

Thus, the “Skeptics” scenario below analyzes performance over three years beginning December 31, 2014, assuming yields for different asset classes are the same as they were on September 30, 2014, but factoring in less aggressive monetary policy. The yields on the Two-Year Treasury Index and the 1-3 Year Corporate Index are adjusted 275 bps higher between year-end 2014 and year-end 2017, the same movement as projected for fed funds. The 10-year Treasury adjusts 126 bps higher to 3.75% by year-end 2017. The Barclays Aggregate Index is assumed to rise gradually, to 3.75%, which is more yield adjustment than the 10-year Treasury, but less than the movement in fed funds. In this scenario, the High Yield Index is again adjusted to maintain its September 30th spread of 450 bps over five-year Treasuries. Assuming the five-year Treasury yield adjusts to 3.50% by year-end 2017, the High Yield Index is assumed to yield 8.00% at the time.

With interest rates rising more slowly than the dot-plot forecast, 10-year Treasuries perform better than in the “Fed Projections” scenario, but still underperform two-year Treasuries. Once again, the higher yield of the 1-3 Year Corporate Index and the High Yield Index lead to more favorable performance than high-quality, longer-term benchmarks.

 

Table 2.  Performance of Key Fixed-Income Categories Under a “Skeptics” Scenario

Source: Barclays, Bloomberg, and Lord Abbett.  The scenario detailed in Table 2 analyzes performance over three years beginning December 31, 2014, with yields on indicated asset classes starting the same level as they were on September 30, 2014.  This scenario assumes a fragile economy that cannot withstand the rate rises projected by the Fed in its September 17, 2014, statement.  Fed funds are assumed to reach 0.75% by year-end 2015, 1.75% by year end 2016, and 2.75% by the end of 2017.  Accordingly, the yield on the two-year U.S. Treasury and the Corporate BBB 1-3 Year Index adjust by 275 bps over the time period.  The yield on the Barclays Aggregate adjusts 134 bps higher through the end of 2017.  The High Yield Index adjusts to yield 8.00% by year-end 2017.  The yield on the 10-year U.S. Treasury adjusts 126 bps higher, to 3.75%, by year-end 2017.
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
The impact of rising interest rates is clear: Regardless of whether rates rise according to projections in the Fed’s September 17th statement, or according to more conservative assumptions based on the futures market, shorter-duration, lower-quality securities likely would outperform longer-duration, high-quality debt.  Conversely, in a recession accompanied by declining rates, shorter-duration, lower-quality securities would be expected to underperform longer-term, high-quality debt. This conclusion is not a surprise to educated investors. Securities with less interest-rate sensitivity should perform better in a rising rate environment. (However, projections should not be considered a guarantee.)

But the analysis of two rising rate scenarios underscores the performance consequences of differences in rate sensitivity. The analysis also reveals the value of higher income streams and the impact of compounding even over periods as short as three years. “Lower in maturity, lower in quality” still seems an appropriate investment mantra in a rising interest rate environment.

 

As represented by the BBB rated component of the BofA Merrill Lynch 1-3 Year U.S. Corporate Index, an unmanaged index comprised of U.S. dollar-denominated investment-grade corporate debt securities publicly issued in the U.S. domestic market with between one and three years remaining to final maturity.
As represented by the BofA Merrill Lynch U.S. High Yield Master II Constrained Index, a market value-weighted index of all domestic and Yankee high-yield bonds, including deferred-interest bonds and payment–in-kind securities. Issues included in the index have maturities of one year or more and have a credit rating lower than BB-/Baa3, but are not in default. The index limits any individual issuer to a maximum of 2% benchmark exposure. Index constituents are capitalization-weighted, based on their current amount outstanding, provided the total allocation to an individual issuer does not exceed 2%. Issuers that exceed the limit are reduced to 2% and the face value of each of their bonds is adjusted on a pro-rata basis. The face values of bonds of all other issuers that fall below the 2% cap are increased on a pro-rata basis. In the event there are fewer than 50 issuers in the index, each is equally weighted and the face values of their respective bonds are increased or decreased on a prorate basis.
The 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. Total return comprises price appreciation/depreciation and income as a percentage of the original investment. Indexes are rebalanced monthly by market capitalization.
This index represents a theoretical rolling 10-year U.S. Treasury note, renewed semiannually to a new higher coupon based on the indicated rise in rates.
Assumes 2% defaults of par value of U.S. high-yield securities per year with 40% recovery of defaulted dollar amount. 
Compounded semiannually, from December 31, 2014, through December 31, 2017.
Represents the aggregate amount that an investment has gained or lost over time, independent of the period of time involved.

 

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