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Until markets were jolted in September by the Federal Reserve's decision to delay the tapering of its bond-buying program, investors had been anticipating that interest rates would go higher. Fed chairman Ben Bernanke's announcement, however, put the tapering plan on hold, prolonging the Fed's lower-for-longer interest rate policy. The decision means that the Fed is unlikely to begin raising the fed funds rate for 14 months or more.
Many investors, however, appear to believe that a rise in short-term interest rates is imminent. Many remain in cash, fearful perhaps that investing in short-term fixed-income securities will immediately expose them to possible losses. But Bernanke consistently has said that decisions about monetary policy will depend on the trajectory of the economy. He has specified, in fact, that raising the fed funds rate, which would not begin until after tapering is concluded, will depend on two factors: inflation and unemployment. As long as core inflation remains below 2.5%, short-term interest rates won't be raised until the unemployment rate falls to 6.5%.
Currently, core inflation is running at 1.2%, according to the Bureau of Economic Analysis' Personal Consumption Expenditure Price Index, Bernanke's preferred measure. Unemployment is 7.3%, according to the Labor Department (as of August 2013; latest data available).
Given the average rate of job creation—177,000 per month since the financial crisis ended—the unemployment rate won't come down to 6.5% until approximately November 2014 according to Bureau of Labor Statistics. That means that short-term interest rates are likely to remain near record lows for more than 14 months.
Source: Bureau of Labor Statistics, Federal Reserve Bank of Atlanta – Jobs Calculator. August data, updated September 6, 2013, seasonally adjusted.
The jobs calculator tool calculates the net employment change needed to achieve a target unemployment rate after a specified number of months. Target unemployment rate of 6.5% and specified time period of 15 months were used in the calculator to create an average monthly payroll needed of 178,840—a close approximation of the 177,000 jobs per month average seen in the last three years. See the Federal Reserve Bank of Atlanta – Jobs Calculator website for more details.
For illustrative purposes only. Forecasts are based on current market conditions and are subject to change without notice.
The longer that short-term interest rates remain near record lows, the costlier it will become for investors with large allocations to cash. With money market mutual funds paying a fraction of a percent per year and inflation at 1.2%, the real return is negative.
But this lower-for-longer period, which has already run for nearly five years, could be extended even further if the economy weakens. And this could happen if government budget issues aren't addressed, according to Rob Lee, Lord Abbett Partner & Director of Taxable Fixed Income. "We still have fiscal issues to address here in the United States, including another debt ceiling negotiation in a few months as well as the possible effects of additional budget cuts from the sequester."
This could hurt job creation, and if new jobs fall below 177,000 per month, the unemployment rate would remain high, and tapering could be postponed again. What if unemployment fell to the 6.5% target, but primarily as a result of declines in labor force participation, as has happened in recent months? This would indicate economic weakness, not strength, so it seems likely that in this case, too, tapering would be further delayed. Moreover, assuming that Janet Yellen, currently vice chair of the Federal Open Market Committee, is confirmed as the next Fed chairman, tapering could be delayed even if inflation passes the 2.5% target, given her dovish reputation.
A better option than cash may be to take on a modicum of credit risk in the form of short-duration fixed income. Short-term, high-yield corporate debt as represented by The Barclays High Yield 'Ba'-Rated 1- 5 Year Index also is particularly attractive, yielding 4.33%, as of September 30, 2013, although there is no guarantee that the yields will continue to be attractive in the future.
Sources: Sources: Barclays and BofA Merrill Lynch Index data.
1 The BofA Merrill Lynch U.S. Treasury Bill 3-Month Index
2 The Barclays U.S. Treasury 1-5 Year Index
3 The BofA Merrill Lynch U.S. Corporate 'A'-rated 1-5 Year Index
4 The BofA Merrill Lynch CMBS Fixed rate 'AAA'-rated 1-5 Year Index
5 The Barclays High Yield 'Ba'-rated 1-5 Year Index
For illustrative purposes only and does not represent any specific Lord Abbett mutual fund or any particular investment. Past performance is no guarantee of future results.
Indexes are unmanaged, do not reflect deduction of fees or expenses, and are not available for direct investment.
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. High-yield securities, sometimes called junk bonds, carry increased risks of price volatility, illiquidity, and the possibility of default in the timely payment of interest and principal. Longer-term debt securities are usually more sensitive to interest rate changes, the longer the maturity of a security, the greater the effect a change in interest rates is likely to have on its price. Mortgage-backed securities are subject to pre-payment risk. 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.
A Note about Risk: The value of investments 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, and as interest rates rise, the prices of debt securities tend to fall. Bonds may also be subject to other types of risk, such as call, credit, liquidity, interest-rate, and general market risks. Longer term debt securities are usually more sensitive to interest rate changes. The longer the maturity date of a security, the greater the effect a change in interest rates is likely to have on its price. Lower-rated debt securities may involve greater risks than higher rated debt securities. Mortgage-backed securities are subject to pre-payment risk. High-yield securities, sometimes called junk bonds, carry increased risks of price volatility, illiquidity, and the possibility of default in the timely payment of interest and principal. No investing strategy can overcome all market volatility or guarantee future results.
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.
An investment in a money market fund is not a bank deposit and is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. Although a money market fund seeks to preserve the value of your investment at $1.00 per share, it is possible to lose money by investing in a money market fund.
The credit quality of the securities in a portfolio are assigned by a national recognized statistical rating organization (NRSRO), such as Standard & Poor's, Moody's or Fitch, as an indication of an issuer's creditworthiness. Ratings range from 'AAA' (highest) to 'D' (lowest). Bonds rated 'BBB' or above are considered investment grade. Credit ratings BB and below are lower-rated securities (junk bonds). High-yielding, non-investment-grade bonds (junk bonds) involve higher risks than investment-grade bonds. Adverse conditions may affect the issuer's ability to pay interest and principal on these securities. The credit quality distribution breakdown is not an S&P credit rating or an opinion of Standard & Poor's as to the creditworthiness of the portfolio.
Yield to maturity is the rate of return anticipated on a bond if held until the end of its lifetime.
The BofA Merrill Lynch U.S. Treasury Bill 3-Month Index is an index of short-term U.S. government securities with a remaining term to final maturity of less than three months.
The Barclays U.S. Treasury 1-5 Year Index includes all publicly issued, U.S. Treasury securities that have a remaining maturity of greater than or equal to one year and less than five years, are rated investment grade, and have $250 million or more of outstanding face value. In addition, the securities must be denominated in U.S. dollars and must be fixed rate and non-convertible.
The BofA Merrill Lynch U.S. Corporate A-Rated 1-5 Year Index is a rating- and maturity-specific subset of the BofA Merrill Lynch U.S. Corporate Index, which tracks the performance of U.S. dollar-denominated investment-grade corporate debt publicly issued in the U.S. domestic market. Qualifying securities must have an investment grade rating (based on an average of Moody's, Standard & Poor's, and Fitch) and an investment-grade rated country of risk (based on an average of Moody's, Standard & Poor's, and Fitch foreign currency long term sovereign debt ratings). In addition, qualifying securities must have at least one year remaining term to final maturity, a fixed coupon schedule and a minimum amount outstanding of $250 million.
The BofA Merrill Lynch CMBS Fixed Rate 'AAA'-rated 1-5 Year Index is a subset of the BofA Merrill Lynch U.S. Fixed Rate CMBS Index, including all securities with an average life less than five years. The BofA Merrill Lynch U.S. Fixed Rate CMBS Index tracks the performance of US dollar denominated investment grade fixed rate commercial mortgage backed securities publicly issued in the U.S. domestic market. Qualifying securities must have an investment grade rating (based on an average of Moody's, Standard & Poor's, and Fitch), a fixed coupon schedule, at least one year remaining term to final maturity and at least one month to the last expected cash flow. In addition, qualifying securities must have an original deal size for the collateral group of at least $250 million, a current outstanding deal size for the collateral group that is greater than or equal to 10% of the original deal size and at least $50 million current amount outstanding for senior tranches and $25 million current amount outstanding for mezzanine and subordinated tranches. Callable perpetual securities qualify provided they are at least one year from the first call date. Fixed-to-floating rate securities also qualify provided they are callable within the fixed rate period and are at least one year from the last call prior to the date the bond transitions from a fixed to a floating rate security. Floating rate, inverse floating rate, interest only and principal only tranches of qualifying deals are excluded from the Index as are all tranches of re-securitized and agency deals. 144a securities qualify for inclusion in the Index.
The Barclays High Yield 'Ba'-rated 1-5 Year Index is a rating- and maturity-specific subset of the Barclays U.S. High Yield Index, which covers the universe of fixed rate, non-investment-grade debt. Eurobonds and debt issues from countries designated as emerging markets (sovereign rating of Baa1/BBB+/BBB+ and below using the middle of Moody's, Standard & Poor's, and Fitch) are excluded, but Canadian and global bonds (SEC registered) of issuers in non-EMG countries are included. Original issue zeroes, step-up coupon structures, 144-As and pay-in-kind bonds (PIKs, as of October 1, 2009) are also included.
Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.
The opinions in Market View are as of the date of publication, are subject to change based on subsequent developments, and may not reflect the views of the firm as a whole. The material is not intended to be relied upon as a forecast, research, or investment advice, is not a recommendation or offer to buy or sell any securities or to adopt any investment strategy, and is not intended to predict or depict the performance of any investment. Readers should not assume that investments in companies, securities, sectors, and/or markets described were or will be profitable. Investing involves risk, including possible loss of principal. This document is prepared based on the information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy and completeness of the information. Investors should consult with a financial advisor prior to making an investment decision.