Topic Tags: Interest Rates

Core vs. Intermediate Government/Credit: Which to Choose?

Our Chart of the Week examines the relative performance of Core and Intermediate Government/Credit fixed income strategies in rising and falling rate environments. The chart shows Core’s annual total return since the 1970s as represented in the blue using the Barclays U.S. Aggregate index. Annual total return of the Barclays Intermediate Government/Credit index is shown in orange. We also include inflation in green, using the CPI’s annual change, and the 10-year Treasury yield in gray. As one can see, Core beat Intermediate Government/Credit and inflation when rates dropped during the 30-year bull run for bonds from the 1980s to today. This is because Core features higher yields and longer duration, the latter of which boosts bond prices when rates drop. But Core lags Intermediate Government/Credit and inflation if rates rise significantly, as we experienced during the 1970s oil crisis. This was again because of Core’s longer duration. In other words, Core’s longer-dated bonds took much longer to be recycled out as rates rose and newer, higher-yielding bonds came to market; as a result, returns lagged.

Our Chart of the Week examines the relative performance of Core and Intermediate Government/Credit fixed income strategies in rising and falling rate environments. The chart shows Core’s annual total return since the 1970s as represented in the blue using the Barclays U.S. Aggregate index. Annual total return of the Barclays Intermediate Government/Credit index is shown in orange. We also include inflation in green, using the CPI’s annual change, and the 10-year Treasury yield in gray. As one can see, Core beat Intermediate Government/Credit and inflation when rates dropped during the 30-year bull run for bonds from the 1980s to today. This is because Core features higher yields and longer duration, the latter of which boosts bond prices when rates drop. But Core lags Intermediate Government/Credit and inflation if rates rise significantly, as we experienced during the 1970s oil crisis. This was again because of Core’s longer duration. In other words, Core’s longer-dated bonds took much longer to be recycled out as rates rose and newer, higher-yielding bonds came to market; as a result, returns lagged.

Going forward, no one knows whether rates will go up or down. We performed projections based on the likely scenario that the Fed hikes 25bp per year for the next three years. We assume a flattening curve and the 10-year Treasury rises 10bp per year. In this scenario, we estimate that Core will beat Intermediate Government/Credit because of its higher yield despite its longer duration. If the economy gets worse, we assume there are no hikes and the 10-year Treasury yield goes to zero in three years. For this case, we estimate that Core will beat Intermediate Government/Credit handily because of both its duration and yield pickup. What it takes for Intermediate Government/Credit to beat Core is extremely strong economic growth or a dramatic inflationary environment where prices of goods skyrocket, during which we assume 0.5% or more of annual increases in the 10-year Treasury yield. Here, Core’s longer duration hurts it more than its higher yield. These estimates do not account for technical market selloffs or buying binges, but show what a perfectly rational market is expected to do.

As a practical takeaway, if investors are deciding between Core vs. Intermediate Government/Credit, this shows that Core is more resilient in the more likely scenarios. On the other hand, if an investor has chosen Intermediate Government/Credit for its lower duration, its performance will be relatively similar to that of Core in all scenarios. Ultimately, both strategies will provide liquidity, diversification, and safety in the event of market stress; relative performance across interest rate environments will not be significant, though core offers a bit higher upside under the most likely interest rate scenario over the next few years.

Is Higher Debt Among Companies Something to Worry About?

As the Federal Reserve maintains interest rates at all time lows, corporate balance sheets continue to benefit from this accommodative environment, as the low rate environment combined with a bull market has allowed corporations to add leverage to their balance sheets at an alarming rate. With borrowing costs so low, corporations have used this debt to finance stock buybacks, dividend growth, and M&A deals.

As the Federal Reserve maintains interest rates at all time lows, corporate balance sheets continue to benefit from this accommodative environment, as the low rate environment combined with a bull market has allowed corporations to add leverage to their balance sheets at an alarming rate. With borrowing costs so low, corporations have used this debt to finance stock buybacks, dividend growth, and M&A deals.

The growth of net debt among the S&P 500 constituents has hit levels not seen in the past 10 years, rising significantly against EBITDA levels. Thus, corporations’ operational cash flows are not expanding quickly enough to keep pace with their growing debt loads. This type of imbalance in past cycles has led companies to cut back on spending and hiring.

While consumers have deleveraged since the 2008 housing crisis, corporations have taken advantage of the low rates and subsequent cheap financing. If the Federal Reserve begins to raise rates or economic growth continues to slow, corporations could struggle to cover interest payments on their outstanding debt, which would likely translate to subpar returns for both equity and debt investors.

Do Rising Interest Rates Mean Higher Cap Rates for Real Estate?

One of the best performing and consistently stable asset classes over the past several years has been real estate. Based on the NCREIF-ODCE Index real estate has returned an annualized 12.7% over the last five years.

One of the best performing and consistently stable asset classes over the past several years has been real estate. Based on the NCREIF-ODCE Index, real estate has returned an annualized 12.7% over the last five years. Much of the sector’s success has been attributed to strong fundamentals which have translated into cap rate1 compression. Although cap rates are at historical lows and unlikely to compress much further, the unusually low interest rate environment combined with the spread between cap rates and risk-free Treasuries continue to make real estate investments look relatively attractive. Going forward, in anticipation of the Fed raising interest rates, we expect the current relatively wide cap rate to Treasury spread will provide a measure of cushion to allow long-term interest rates to rise without drastically impacting cap rates and the overall value of real estate.

 

1Cap rate is the net operating income divided by property value

Global Bonds and Negative Yields

This week’s chart examines the change in yield for global sovereign debt. While we have been in a low interest rate environment since 2008, over the last three years, we have seen negative yielding bonds move from 0% of the developed bond universe to 38%. A staggering number indeed, this has been the by-product of anemic global growth and aggressive monetary policies in Europe and Japan.

This week’s chart examines the change in yield for global sovereign debt. While we have been in a low interest rate environment since 2008, over the last three years, we have seen negative yielding bonds move from 0% of the developed bond universe to 38%. A staggering number indeed, this has been the by-product of anemic global growth and aggressive monetary policies in Europe and Japan.

One of the consequences of a negative rate environment is increased demand for higher yielding assets. Through the second quarter, U.S. high yield and emerging market debt have returned 9.1% and 10.3%, respectively. In addition to attractive yields, these asset classes have benefitted from stability in commodity prices and minimal exposure to the Brexit event. Should these conditions persist going forward, expect investor preference for credit and higher yielding bonds to continue, given this historically low interest rate environment.

What Does the Brexit Mean for the Fed and Interest Rates?

While the Brexit won’t actually take place until at least sometime next year, many investors and economists are concerned about the ramifications this will have on the global economy. The Federal Reserve is no exception. Prior to the vote, the Fed warned about the effects the Brexit might have, and since then has indicated it would hold off raising interest rates due to these risks. M

While the Brexit won’t actually take place until at least sometime next year, many investors and economists are concerned about the ramifications this will have on the global economy. The Federal Reserve is no exception. Prior to the vote, the Fed warned about the effects the Brexit might have, and since then has indicated it would hold off raising interest rates due to these risks. Markets now are giving almost no chance of a rate hike at next week’s meeting and, as shown in the chart above, there is still only a small chance of an increase in September or November. Both the futures market, which is used to calculate the odds above, and most economists give about a 50/50 chance of a hike in December. So while the Fed initially expected to raise interest rates four times in 2016, it seems now there’s a strong chance that there won’t be any.

Equity Returns Post Brexit

The United Kingdom’s (UK) vote to leave the European Union on June 23 was an unprecedented event that impacted markets across around the world. While this exit won’t actually take place for another two years, equities sold off in a knee-jerk fashion as investors feared the ramifications on the global economy. Due to the heavy exposure to Europe, non-U.S. developed markets suffered the most, losing nearly 10% before rebounding.

The United Kingdom’s vote to leave the European Union on June 23rd was an unprecedented event that impacted markets around the world. While this exit won’t actually take place for another two years, equities sold off in a knee-jerk fashion as investors feared the ramifications on the global economy. Due to the heavy exposure to Europe, non-U.S. developed markets suffered the most, losing nearly 10% before rebounding.

With the U.S. viewed as a safe haven, domestic equities have fared relatively well in the Brexit aftermath. The U.S. dollar appreciated following the decision while the British pound slumped to a 30 year low against the greenback. Emerging market (EM) currencies have also depreciated against the dollar however EM equities have been one of the stronger performers. This asset class has benefitted from the U.S. Federal Reserve indicating it will not make any significant interest rate movements due to the risk the Brexit poses to the economy. Only a few days after the UK vote, EM equities rallied for its biggest weekly gain since March. While the Brexit will undoubtedly have long-term ramifications, many of which are currently unclear, equity markets have rebounded from the initial sell-off.

Will the Emerging Market Equity Rally Continue?

For this week’s chart of the week we take a look at the year to date return stream of emerging market equities, as measured by the MSCI Emerging Markets (“EM”) Index, which has been on a wild ride as oil prices fluctuated over the first three months of the year.

For this week’s chart, we look at the year-to-date return stream of emerging market equities, as measured by the MSCI Emerging Markets (“EM”) Index, which has been on a wild ride as oil prices fluctuated over the first three months of the year.

After reaching their 2016 low in the middle of January, emerging markets embarked on a sharp rally in the second half of February that continued through March and early April. On February 10th, due to concerns about the impact of a further rate hike on both domestic and foreign economies, Federal Reserve Chair Janet Yellen signaled postponement on the March rate hikes. The postponed rate hike decision coupled with continued weakness of the dollar and stabilization of commodities led to the rally starting on February 12th.

Earlier this week, China released positive upbeat news, announcing its exports rose 11.5% compared to a year earlier and surpassing analyst expectations which led to a strong April start for emerging market equities. As volatile as this first quarter of 2016 was, we frequently remind clients of the importance of having a long-term approach to investing as we have seen the EM index swing from significantly negative in January to +6.7% year to date as of April 13th. Certainly, EM investments will demonstrate elevated volatility across market cycles, but it is critical to maintain a long-term focus on their performance as it relates to total portfolio returns.

Dividends and Buybacks are Flat… Just Like the Market

Following the recession, dividends and stock repurchases had a significant run, growing about 28% per year, reaching a new record of $241 billion in March 2014. While dividends continue to grow, buybacks have fallen in the last 18 months, leaving the combined total mostly flat. Not surprisingly, the market has also been relatively flat over the last year and a half.

Following the recession, dividends and stock repurchases had a significant run, growing about 28% per year, reaching a new record of $241 billion in March 2014. While dividends continue to grow, buybacks have fallen in the last 18 months, leaving the combined total mostly flat. Not surprisingly, the market has also been relatively flat over the last year and a half.

Stock buybacks reduce the amount of shares outstanding for a company which causes earnings per share (EPS) to increase since the same amount of earnings over fewer shares outstanding creates a higher EPS value. EPS is a metric used in the determination of stock price, so a higher EPS value provides support for the stock price to appreciate in the near term. 

A significant source of funding for stock buybacks in recent years came from the ability to borrow at short-term rates near zero. As interest rates continue to rise, companies will be less inclined to fund buybacks in this manner. While buybacks are estimated to be higher for the first quarter of 2016, going forward they could be scaled back significantly, which would be a further drag on equity returns.

2016 Market Preview

January 2016

Similar to previous years, we offer our annual market preview newsletter. Each year presents new challenges to our clients, and 2016 is off to a volatile start with equity markets down significantly, oil dropping below $30, the Fed poised to further increase interest rates, and fears of a China slowdown rippling through the markets. However, other headlines will emerge as the year goes on, and it is critical to understand how asset classes will react to each new development and what such reactions will mean to investors. The following articles contain insightful analysis and key themes to monitor over the coming year, themes which will underlie the actual performance of the asset classes covered.

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The Implications of a Stronger Dollar on Emerging Market Investments

In 2015, the emerging market equity index declined 14.9%. While there are a variety of explanations for this, one can not underestimate the impact of a stronger dollar. In fact, currency losses were responsible for more than 60% of the decline for U.S.-based investors.

In 2015, the emerging market equity index declined 14.9%. While there are a variety of explanations for this, one can not underestimate the impact of a stronger dollar. In fact, currency losses were responsible for more than 60% of the decline for U.S.-based investors. This week’s chart of the week examines the mechanics of how a stronger dollar can drive losses for emerging market investments.

Typically when U.S. interest rates rise, the dollar strengthens relative to foreign currencies. Investors oftentimes onshore investments during rising rate periods, and as a result, the country as a whole “exports” less dollars. The commodity price declines — especially oil — have been a major contributor to the rise in the U.S. dollar as the U.S. exports fewer dollars per unit. In our chart, we use the quantity of oil imported multiplied by its price as a proxy for the amount of dollars exported each month. During 2014, the United States imported an average of $26 billion a month in oil. During the first ten months of 2015, the U.S. imported an average of $14 billion a month, clearly a large drop and in conjunction with dollar strengthening and emerging market equity declines.

So why do emerging market investments fall? Emerging market economies often depend on dollar-denominated revenues to service debts as well as manage interest rates and exchange rates. If emerging market countries are receiving less dollars from the U.S., they face increased pressures from higher borrowing costs and lower dollar-denominated revenues. In addition, with less revenue, it is more difficult to promote internal growth via exchange rates or interest rate policies. Unfortunately, as U.S. interest rates are poised to rise further in 2016, emerging markets are likely to experience heightened volatility as a result.