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Market View

There’s a better strategy than trying to guess the timing of interest-rate changes, especially given post-election uncertainty. 

There has been tremendous volatility in the bond market over the past week. When it first appeared that Donald Trump was going to win the U.S. presidential election on the evening of November 8, bond yields initially tumbled before reversing course, mirroring the response of the equity market. By this morning (Monday, November 14), the 10-year Treasury yield had jumped to 2.25%, a 40 basis-point move since Tuesday, according to Bloomberg, as the market began to speculate that the president-elect will pursue a range of policies to stimulate the economy, including increased spending and tax cuts, which may lead to higher deficits and higher inflation. Can investors manage their bond portfolios based on the timing of such interest-rate moves?  

On many occasions, we have written about the challenges of predicting the direction of interest rates.  Charts 1 and 2 illustrate why we believe it may be imprudent to build a portfolio based on one’s conviction about the future path of interest rates. 

The experts tend to get it wrong. Chart 1 maps out the results of The Wall Street Journal Economic Forecasting Survey, based on a canvassing of 50 economists, including their six-month forecast of the 10-year U.S. Treasury bond yield. The gray dot indicates the consensus six-month forecast, while the gold line is the actual path of the 10-year yield. The consensus has called for higher rates in each of the past five surveys, while rates actually have fallen four of the five periods. In addition, the average consensus forecast level of rates was off by more than 70 basis points in these periods—and that’s only looking out six months.

 

Chart 1: Experts Continue to Miss on Interest-Rate Forecasts
Six-month interest-rate forecast surveyed by The Wall Street Journal versus actual yield movement for indicated periods

Source: The Wall Street Journal Economic Forecasting Survey and the U.S. Department of the Treasury.  As of 06/30/2016. Data represent the six-month forecast and actual yield for the 10-year U.S. Treasury bond. The Wall Street Journal surveys a group of nearly 50 economists on more than 10 major economic indicators on a monthly basis. 
The historical data are for illustrative purposes only, do not represent the performance of any specific portfolio managed by Lord Abbett or any particular investment, and are not intended to predict or depict future results.  Investors may experience different results.  Due to market volatility, the market many not perform in a similar manner in the future. Market forecasts and projections are based on current market conditions and are subject to change without notice.  A basis point is one one-hundredth of a percentage point.  Past performance is no guarantee of future results.

 

The market gets it wrong. Chart 2 compares the market prediction for the future path of the fed funds rate (as measured by the pricing in the fed funds futures market) with the actual fed funds rate. As illustrated in the gray dotted lines, the futures market consistently has been pricing in rate hikes since 2009, which seven years later we are still in a world with the fed funds rate target range of 0.25–0.50%.

 

Chart 2: Markets Have Struggled to Predict the Pace of Hikes
U.S. fed fund futures at different points in time (as of 09/30/2016)

Source: U.S. Federal Reserve Board, Bloomberg Finance LP, Haver Analytics, and DB Global Markets Research. 
Past performance is no guarantee of future results. For illustrative purposes only, and does not represent the performance of any specific portfolio managed by Lord Abbett or any particular investment. Market forecasts and projections are based on current market conditions and are subject to change without notice. Projections should not be considered a guarantee.

 

At Lord Abbett, our approach to managing fixed-income portfolios is not based on making major bets on the direction of interest rates, which we do not believe is the most consistent way to generate returns. Instead, we focus our efforts on areas where we believe we can consistently add value: sector rotation and individual security selection, employing in-depth research and rigorous risk management.

Despite the reality of these two charts, it seems that many investors and their financial advisors do try to make large portfolio-allocation decisions based on their view of the direction of rates, tactically moving in and out of certain asset classes. One prime example of this can be seen in floating-rate bank-loan mutual fund flows. 

In the midst of the “taper tantrum” fears in 2013 (when the Federal Reserve threatened to taper its quantitative easing program and the market reacted), the Lipper Bank Loan category nearly doubled in size, taking in more than $60 billion in net flows. In fact, the category received positive flows over a stretch of 95 straight weeks between June 2012 and April 2014, as many investors had anticipated that the beginning of the Fed’s tightening cycle was imminent. But then it became clear that the Fed’s “lift-off” was going to be pushed out further into the future. Investors reacted by reversing course and withdrawing approximately $60 billion from the category, with consistent outflows almost every week from April 2014 through mid-2016, according to The Wall Street Journal.  More recently, flows have turned positive once again, as short-term rates have moved higher, and a December rate hike seems likely. 

Several times in this space, we have spelled out many reasons to consider including floating-rate loans in a portfolio besides this simply being a play on interest rates. Namely, floating-rate loans historically offered attractive income with little interest-rate sensitivity, delivered strong risk-adjusted returns, and provided valuable portfolio diversification benefits. Investors might have been well served by maintaining an allocation to floating-rate loans over the past five years rather than timing their entry and exit. 

Over the past five years, floating-rate loans have generated higher returns than the Bloomberg Barclays U.S. Aggregate Bond Index, and have done so with less volatility. While loans have lagged the stellar returns of the U.S. high-yield bond market, loans have had less than half the volatility of that asset class (see Table 1). With this return profile, floating-rate loans have had higher risk-adjusted returns than both intermediate investment-grade and high-yield bonds.

 

Table 1: Short-Duration Corporates, Floating-Rate Loans, and Portfolio Blends Have Offered Historically Strong Risk-Adjusted Returns   

Source: Bloomberg.  U.S. high yield represented by the Bank of America Merrill Lynch U.S. High Yield Index. Intermediate investment-grade bonds represented by the Bloomberg Barclays U.S. Aggregate Bond Index. Floating-rate loans represented by the CSFB Leveraged Loan Index. Short-duration bonds represented by the Bank of America Merrill Lynch U.S. Corporate 1-3 Year Index. 
Past performance is no guarantee of future results. For illustrative purposes only, and does not represent the performance of any specific portfolio managed by Lord Abbett or any particular investment. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

 

Looking Ahead
So how should one consider preparing his or her portfolio for the future? We would suggest building a fixed-income portfolio that combines multiple asset classes that are not highly correlated with one another. One simple combination we have highlighted is illustrated in Chart 3, a blend of floating-rate loans (as represented by CSFB Leveraged Loan Index) and high-quality intermediate bonds (as represented by the Bloomberg Barclays U.S. Aggregate Index). High-quality bonds have tended to do well in a stable or declining interest-rate environment, while floating-rate loans generally have done well in a stable or rising-rate environment. By the powers of diversification, these two asset classes working together have led to lower risk and higher risk-adjusted returns than either asset class on its own. [Asset allocation and diversification do not eliminate the risk of experiencing investment losses. Diversification does not guarantee a profit or protect against loss in declining markets.]

 

Chart 3: A Diversified Fixed-Income Portfolio May Offer Risk/Reward Benefits
Five-year risk reward as of 10/31/2016

Source: Bloomberg. Intermediate investment-grade bonds represented by the Bloomberg Barclays U.S. Aggregate Bond Index. Floating-rate loans represented by the CSFB Leveraged Loan Index. Short-duration bonds represented by the Bank of America Merrill Lynch U.S. Corporate 1-3 Year Index.
Past performance is no guarantee of future results. For illustrative purposes only, and does not represent the performance of any specific portfolio managed by Lord Abbett or any particular investment. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment. Neither diversification nor asset allocation can guarantee a profit or protect against loss in declining markets.

 

Given the concerns that the president-elect’s policies may put pressure on long-term interest rates, investors may want to further reduce the duration of their portfolios. As we have pointed out earlier, short-duration corporate bonds historically have had lower volatility than intermediate-term bonds, providing a source of potential portfolio stability, and have generated positive returns even in the face of rising interest rates. A blend of short-duration bonds and floating-rate loans (see Chart 3) may provide high income, while further reducing volatility and interest-rate sensitivity.

Of course, these are simple examples with just two asset classes. One also can consider high-yield bonds, which may offer attractive income and the potential for high total return, and historically have performed well during periods of rising Treasury yields, or inflation-linked securities, to protect against the corrosive effects of an increase in inflation. While each of these asset classes has strong merit on its own, a diversified fixed-income portfolio with allocations to each of them may work best, in our opinion.

It remains to be seen if the market’s initial knee-jerk reaction to the election will lead to a sustained move to higher rates, or if this was an over-reaction that may soon reverse itself. Either way, we believe a portfolio that combines high-quality bonds with high-yield bonds, low-duration bonds, and floating-rate loans may be well positioned to weather any interest-rate scenario.

In an upcoming Muni Matters column, we will examine the relatively orderly response of the municipal bond market to the recent rise in interest rates. For new investors, rates are much more attractive than they were in July. Investors might want to consider adding a tax-free component to their fixed-income portfolios. 

 

MARKET VIEW PDFs


  Market View
  U.S. Market Monitor

RELATED FUND
The Lord Abbett Floating Rate mutual 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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The Lord Abbett Short Duration Income Fund seeks to deliver a high level of current income consistent with the preservation of capital. Learn more.

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