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Market View

A flexible, multi-sector approach can help investors navigate the shifting economic and monetary policy currents.

For several years now, investors have been expecting an imminent interest-rate hike by the U.S. Federal Reserve (Fed), and for clues they have been parsing every statement from the Fed’s policy-making arm, the Federal Open Market Committee (FOMC). But with the future course of monetary policy so data-dependent, and recent reports on the U.S. economy somewhat ambiguous in terms of future growth rates, the Fed’s so-called forward guidance has been anything but forward or guiding.

In fact, according to a recent study1 by the Federal Reserve Bank of St. Louis, the FOMC’s statements have done more to sow uncertainty than to provide clarity on the subject. We don’t disagree. The FOMC’s most recent statement had some observers convinced that the first rate hike will occur in December 2015. But others were equally convinced that the decision will, as always, be dependent on the economic data, and that may mean holding off on a rate hike until sometime in 2016. The much stronger-than-expected October employment report released on November 6 seemed to strengthen the case for a December rate hike.

But that same morning, Chicago Fed President Charles Evans, a voting member of the FOMC, tried to dampen expectations, citing a “weak foreign economy.”     

Of course, this uncertainty has significant implications for fixed-income investors. As history has shown, during periods of economic growth and rising interest rates, credit-sensitive sectors, such as bank loans and high-yield bonds, and equities performed well. In weaker economic environments marked by declining interest rates, strong performance typically derives from interest-rate sensitive sectors, such as U.S. Treasury bonds and higher-quality fixed-income securities. Chart 1 shows the markedly opposing correlations of credit-sensitive and interest-rate sensitive bonds to U.S. Treasuries—a reflection of their contrasting performance under the economic scenarios described above. 

 

Chart 1. Interest-Rate Sensitive Sectors Had a High Correlation with U.S. Treasuries
Correlation with the Barclays U.S. Government Bond Index, December 31, 1997–September 30, 2015

Source: Morningstar.
1Barclays U.S. Government Bond Index. 2Barclays U.S. Aggregate Bond Index. 3Barclays U.S. Treasury U.S. TIPS Index. 4Barclays U.S. Corporate Baa-Rated Index. 5BofAML U.S. Corporate BBB-Rated 1-3 Year Index.6Barclays U.S. Corporate High Yield Index. 7S&P 500 Index. 8BofA Merrill Lynch All Convertibles All Qualities Index. 9Credit Suisse Leveraged Loan Index. 10Deutsche Bank U.S. CPI Breakeven Inflation 5-Year Swap Indexes.  Please refer to index definitions below.
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. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment. Investors may experience different results. Due to market volatility, the market may not perform in a similar manner in the future.
Past performance is no guarantee of future results. Correlation is a statistic that measures the degree of association between two variables. 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.
For illustrative purposes only and does not represent any specific Lord Abbett mutual fund or any particular investment. 

 

Why Guess Which Way the Wind Is Blowing?
The possible impact of different economic environments on key fixed-income sectors may be anticipated, as shown in Chart 1. But the timing of an interest-rate move is another matter, according to Lord Abbett Fixed-Income Product Strategist Stephen Hillebrecht. “Over the past several years, many investors were convinced that rates were destined to shoot higher, but have found themselves in a low-rate environment for much longer than expected,” Hillebrecht said. “Even the Fed has been lowering its expectations for rate hikes over the past several months.” Although a December rate hike now appears to be more likely, with the uncertainty around the economic outlook, rates may continue to stay relatively low. In any case, he continued, “a duration bet based on a guess about the direction of interest rates is not recommended.  Such strategies have tended to disappoint in recent years.”

As we noted in a recent Market View ("Bonds: A Multi-Pronged Strategy to Counter Fed Concerns"), simple diversification strategies can provide support for a variety of economic and monetary scenarios. Adding investment-grade, short-term, and floating-rate strategies, for example, to the fixed-income portion of a portfolio can work as a hedge against uncertainty.     

Another alternative to consider is to invest in an actively managed and flexible multi-sector strategy that not only can invest across a broad spectrum of fixed-income sectors (for broad diversification) but also can shift its weighting among those sectors as circumstances warrant (tactical allocation). A multi-sector strategy might include:

▪ high-yield bonds, which may offer attractive income opportunities in a slow-growth, or even improving, economy;

▪ investment-grade bonds, which may perform well during “risk-off” periods and thus reduce portfolio volatility;

▪ and equity-related securities (stocks and convertibles) which not only can lower the portfolio’s interest-rate sensitivity (because they tend to do well in an improving economy or in a period of rising rates) but also offer the potential to capture the upside of the equity market.

As the historical data in Table 1 show, fixed-income sectors respond to economic and market developments differently, resulting in widely variable returns. A passive investment strategy likely will not capture the tactical opportunities that these differences can create.

 

Table 1. Returns Among Key Fixed-Income Sectors Have Varied Widely
U.S. fixed-income sector returns, December 31, 2004–September 30, 2015

Source: Barclays Live and Credit Suisse. Sector returns shown are Barclays indexes as follows: U.S. Aggregate Bond Index. U.S. MBS Fixed Rate Index, U.S. Corporate Investment Grade Index, Municipal Bond Index, U.S. Corporate High Yield Index, U.S. Treasury Index, U.S. TIPS Index, ABS Index, and U.S. Agency Index. Credit Suisse Leveraged Loan Index used for leveraged loans. Please refer to index definitions below.
Past performance is no guarantee of future results. Current performance may be higher or lower than the performance data quoted. This historical table is an illustration of the most commonly used indexes representative of various sectors of the bond market and does not depict or predict the performance of any Lord Abbett mutual fund or any particular investment. Please note not all sectors are represented nor is this an asset allocation recommendation.
Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment. 

 

Today, yields are highest in the more credit-sensitive categories, such as bank loans and in high-yield corporates, both in the United States and in emerging markets. (See Chart 2.) Interest-rate sensitive sectors, such as U.S. government bonds, are returning significantly less. (Yields on some 10-year government bonds in overseas markets are even lower.) 

 

Chart 2: A Wide Disparity in Current Yields Offers Opportunity for Active Managers
Yields, by category, as of September 30, 2015

1Barclays U.S. Government Index. 2Barclays Investment Grade CMBS Index. 3Barclays U.S. MBS Index. 4Barclays U.S. Corporate Baa-Rated Index. 5J.P. Morgan CEMBI Investment Grade. 6Credit Suisse Leveraged Loan Index. 7BofA Marrill Lynch U.S. Corporate High Yield Master II Index. 8J.P. Morgan CEMBI Non-Investment Grade. Please refer to index definitions below.
Past performance is no guarantee of future results. For illustrative purposes only and does not represent any specific Lord Abbett mutual fund or any particular investment. 
Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

 

“Many investors are looking for income in a yield-starved world,” said Hillebrecht. “But given the uncertainty—whether it’s the timing of the Fed’s rate hike, a slowdown in China, disappointing global growth, commodity price volatility, or any number of other concerns—and given the wide divergence in bond sector returns in different environments, simply investing in the sector or asset class with the highest yield might not be prudent.” 

Instead of trying to guess which way the wind is blowing in terms of economic growth and monetary policy, investors might be better advised to employ an actively managed multi-sector strategy that identifies the securities with the best relative valuation by sector and uses sophisticated investment techniques to adjust weightings and sector positioning as market opportunity changes—without making significant bets on the direction of interest rates, a strategy that has proved to be inherently risky.    

 

1 Stephen D. Williamson, “Current Federal Reserve Policy Under the Lens of Economic History: A Review Essay,” Federal Reserve Bank of St. Louis, July 2015.

 

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