Topic Tags: Interest Rates

Is It Finally Going to Happen Next Week?

In testimony before the House Financial Services Committee on November 4, Federal Reserve Chairwoman Janet Yellen remarked that a rate hike was still a “live possibility” in December, should economic data remain supportive.

In testimony before the House Financial Services Committee on November 4, Federal Reserve Chairwoman Janet Yellen remarked that a rate hike was still a “live possibility” in December, should economic data remain supportive. Prior to that comment, the market was unsure of any policy change at the Fed’s December meeting, with the Fed Fund’s Futures market implying a  50% probability of a rake hike. After Yellen’s comments, the probability of a hike in December jumped to nearly 70%, and currently sits at 80%, thanks to strong payroll reports over the last two months and further hawkish comments from FOMC members.

Despite this guesswork, Yellen and other members of the FOMC have stressed that the timing of the first rate hike in over nine years is less important that the pace of successive increases. While the futures market hasn’t been an overly reliable predictor of the future path of the Fed Funds rate, it is worth noting that the market appears to accept the Fed’s pledge to enact future increases in a slow and steady manner. Assuming a 0.25% increase on December 16 as a near certainty, the futures market doesn’t imply any meaningful probability of the next increase until the March 2016 meeting, with the most likely landing spot of the Fed Funds rate to be between 0.75% and 1.00% at the end of 2016. While a Fed Funds rate of 1.00% would be a notable shift from the Fed’s post-crisis zero interest rate policy, it would still be seen as highly accommodative in a historical context, and supportive of future economic growth.

How to Position Fixed Income Portfolios for the Rate Hike

October 2015 Investment Perspectives

Much has been written and discussed in the media about when the rate hike will begin and the pace at which it will occur. Ultimately, the timing and pace are difficult to predict because they depend on many moving parts, including unemployment, inflation, and a host of unpredictable economic and political factors. The right question to ask is: How should an institutional investor position a fixed income portfolio for the rate hike, regardless of the associated timing and speed?

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Has the Fed “Missed the Boat”?

The wait for the Federal Reserve to raise interest rates seems to be endless. Unemployment has fallen below the Fed’s desired level and inflation- when adjusted for the drop in oil prices – is just under target.  At the beginning of this year, many predicted September would be the right time for it to finally happen.

The wait for the Federal Reserve to raise interest rates seems to be endless. Unemployment has fallen below the Fed’s desired level and inflation — when adjusted for the drop in oil prices — is just under target. At the beginning of this year, many predicted September would be the right time for it to finally happen. Even with bad news coming out of China and other parts of the world hurting domestic financial markets, until the actual meeting, economists were still split on whether there would be a rate increase. But, clearly, there wasn’t.

Data suggests that a rate hike by the Fed in September would have been poor timing. Initial rate increases generally occur during periods of strong earnings growth. But for the past year, earnings have been relatively flat, and with global economies struggling this trend doesn’t seem likely to change. Additionally, after a rate increase valuations tend to fall. With the trailing 12-month P/E ratio for the S&P 500 dropping from 18.6x to just under 17x in the last two months stock prices have already undergone a sizeable correction. Any Fed action at this point in time would likely only lead to further losses.

Impact of Higher Interest Rates on High Yield Bonds

Under the Fed’s zero interest rate policy, high yield bonds have enjoyed a terrific run of performance. For the five year period ending June 30, 2014, the Barclays U.S. Corporate High Yield index produced an impressive annualized return of 14.0% per year. However, returns in this more speculative portion of the bond market have been disappointing since last summer, when the high yield spread over Treasuries reached a multi-decade low of 221 basis points.

Under the Fed’s zero interest rate policy, high yield bonds have enjoyed a terrific run of performance. For the five-year period ending June 30, 2014, the Barclays U.S. Corporate High Yield index produced an impressive annualized return of 14.0% per year. However, returns in this more speculative portion of the bond market have been disappointing since last summer, when the high yield spread over Treasuries reached a multi-decade low of 221 basis points. The index fell 0.4% in the twelve months ending June 30, 2015, and has continued to show weakness, falling another 1.9% through the middle of August.

This week’s chart examines the past relationship between high yield spreads and rate tightening cycles.1  Although there certainly isn’t a perfect correlation, tightening activity by the Fed has often caused high yield spreads to widen, significantly impacting total return potential. It is no secret that low and stable interest rates are good for speculative companies that are active in the debt markets. While a rake hike doesn’t spell impending doom for the entire high yield universe, some of the more speculative borrowers who have become accustomed to borrowing at ultra-low rates could be in trouble, particularly if the Fed embarks on a prolonged period of successive rate hikes. As we prepare for the first Fed rate hike — likely later this fall — it will be important to pay close attention to high yield exposure within investment portfolios as well as manager positioning within the high yield space.

1 Most recent rate tightening lines refer to the end of QE 1 and 2 and the start of the Fed’s tapering

The Impact of Interest Rates on Real Estate Returns

As the U.S. faces a potential interest rate hike this fall, it is worthwhile to review the impact of interest rates on the real estate sector. This week’s chart looks at the historical performance of the NFI ODCE Index versus the 10-Year Treasury.

As the U.S. faces a potential interest rate hike this fall, it is worthwhile to review the impact of interest rates on the real estate sector. This week’s chart looks at the historical performance of the NFI ODCE Index versus the 10-Year Treasury. The correlation between the two variables is positive but weak, owing in part to a time lag between the change in interest rates and when the change impacts property values.

A moderate interest rate hike after the Financial Crisis may be viewed as the Fed’s vote of confidence that we are seeing economic recovery. Factors that drive interest rates up — such as inflationary pressures from economic growth — cause real estate fundamentals to improve and potentially offset the negative impacts of rising rates. Additionally, we expect to see income rise as property managers pass on higher interest rates to tenants by increasing rents, thus providing a partial hedge against rising rates. While we are still in the initial expansion stage, economic growth and rising interest rates should prove accretive for real estate investments.

Relative Yields for REITs and MLPs Trending Up?

Given the prolonged low rate environment in the aftermath of the credit crisis, investors have been on a continual search for yield. Historically, REITs and Master Limited Partnerships (“MLPs”) have been among the highest yielding asset classes, which led to strong performance in the years following the 2008 financial crisis.

Given the prolonged low rate environment in the aftermath of the credit crisis, investors have been on a continual search for yield. Historically, REITs and Master Limited Partnerships (“MLPs”) have been among the highest yielding asset classes, which led to strong performance in the years following the 2008 financial crisis. However, since the taper tantrum in May of 2013 MLPs and REITs have underperformed the S&P 500 by 1,136 and 648 bps, respectively.1 Currently, REITs2  and MLPs3  are yielding 3.8% and 6.0% compared to the S&P 500 yield of 1.9% as of May 2015.

This week’s chart looks at the historical relative yields of REITS (red lines) and MLPs (blue lines) compared to the S&P 500. The chart shows that if you owned MLPs or REITs since June 2006, on average, you were receiving 3x and 2x yield over the S&P 500 respectively. However, by early 2013 both MLPs and REITs looked expensive based on their yields relative to the S&P.4 Of course, given the underperformance of both MLPs and REITs over the last few years, the relative yields of both asset classes are again starting to look more attractive. REITs still seem a little expensive as yields remain relatively low (compared to history) but MLP yields (relative to the S&P) are now above their long-term average and look relatively attractive, and may present an opportunity for investors to boost portfolio returns.

1 As of May 29, 2015
2 REITs are represented by the FTSE NAREIT All Equity REITs Index
3 MLPs are represented by the Alerian MLP Index
4 Prices are inversely related to yields: if the yield is below the average it is more expensive

Compelling Valuations for Energy Distressed Debt

Given the environment of record issuance and low yields, one is hard-pressed to find fixed income bargains. With the S&P 500 and P/E ratios at record peaks, bargains in equities are similarly few and far between. Energy distressed debt, however, is presenting extraordinary bargains.

Given the environment of record issuance and low yields, one is hard-pressed to find fixed income bargains. With the S&P 500 and P/E ratios at record peaks, bargains in equities are similarly few and far between. Energy distressed debt, however, is presenting extraordinary bargains. Since the energy dislocation began, an unprecedented amount of high yield energy bonds, especially those of shale fracturing E&P companies, have been trading in distressed/stressed territory. As shown in this week’s chart, the bars represent the par value of U.S. high yield energy bonds. The blue bars show the cross-section for May 2015, when $2.5 billion of bonds were priced at zero to 20 cents on the dollar, $2.1 billion were at 20 to 40 cents on the dollar, $7.0 billion were at 40 to 60 cents on the dollar and $19.9 billion were at 60 to 80 cents on the dollar. These values sum to $32 billion, or 15%, of bonds trading between zero and 80 cents on the dollar, which is known as distressed/stressed territory. Contrast this with June 2014, shown in the red bars, when only $0.8 billion, or less than 1%, were distressed/stressed. Clearly, this is an opportunity set that has emerged in the last twelve months and could pay off for investors.

There are two key channels through which investors can access this unprecedented opportunity. One is investing with an energy direct lender, which has two advantages. First, direct lenders can buy into a company’s debt at the top of the capital structure, above any existing bank loans and high yield bonds. This, in turn, gives the investor first-in-line access to the company’s assets in the event of a liquidation. Second, a direct lender can create further protection by negotiating heavy covenants, in contrast to the covenant-light bank loans and high yield bonds existing in the marketplace today.

The second approach is investing with a manager that specializes in buying distressed debt and working with the issuer through a restructuring to extract outsized value from the position. Because such managers would invest in existing covenant-light paper, it is beneficial to choose one that diversifies across oil and gas, coal, electric utilities, and alternative energy.

While distressed energy debt may not be appropriate for all institutional investors, it could also prove accretive to clients in the coming years. As we have seen many times in the past, buying at depressed prices often leads to outsized returns in subsequent years. Given the overall high valuations in the financial markets, we believe distressed energy offers a compelling valuation at this time and could help boost future portfolio returns.

Which Equity Sectors are Most Sensitive to Rising Interest Rates?

Over the past few years there has been much discussion on the low interest rate environment and what will happen once interest rates begin to rise. Though the Fed has delayed raising its overnight lending rate for far longer than many people initially expected, it seems likely that it will finally begin to raise rates later this year. Coupled with the fact that the 10 yr Treasury yield is once again below 2% and approaching its historical low, an increase in interest rates seems very likely.

Over the past few years, there has been much discussion on the low interest rate environment and what will happen once interest rates begin to rise. Though the Fed has delayed raising its overnight lending rate for far longer than many people initially expected, it seems likely that it will finally begin to raise rates later this year. Coupled with the fact that the 10 yr Treasury yield is once again below 2% and approaching its historical low, an increase in interest rates seems very likely.

This Chart of the Week examines what has happened historically to the sectors of the S&P 500 index when rates on the 10 yr Treasury rise substantially. The chart compares the average monthly returns during seven rising rate periods to the average monthly returns during this entire timeframe. As a whole, the S&P 500 has generally outperformed during these time periods, along with most sectors. Industries that tend to be more cyclical, such as information technology, consumer discretionary, and materials featured the largest outperformance. On the other hand, more conservative sectors failed to beat their averages, with utilities and telecom delivering negative monthly returns. Though it is important to remember that historical results may not always persist in the future, the largely positive returns shown in the chart should help ease the fears of an equity market correction when rates begin to rise.

Yield Compression in the Eurozone

In January, the European Central Bank (ECB) officially announced its much talked about Quantitative Easing (QE) program, which will purchase a total of about €1.1 trillion (€60 billion per month) of bonds through September 2016. As was the reasoning behind QE here in the U.S., the hope in Europe is that QE will lower borrowing costs, which in turn will spur economic growth and inflation. When the rumor mill started buzzing in November about a possible QE program, forward looking investors began snapping up bonds, but what they didn’t count on was the large range of maturities the ECB would be purchasing.

In January, the European Central Bank (ECB) officially announced its much talked about Quantitative Easing (QE) program, which will purchase a total of about €1.1 trillion (€60 billion per month) of bonds through September 2016. As was the reasoning behind QE here in the U.S., the hope in Europe is that QE will lower borrowing costs, which in turn will spur economic growth and inflation. When the rumor mill started buzzing in November about a possible QE program, forward-looking investors began snapping up bonds, but what they didn’t count on was the large range of maturities the ECB would be purchasing.

On March 5th, Mario Draghi, President of the ECB, announced the details of the QE program and surprised markets by stating that purchases would include issues with maturities as far out as 30 years, causing a compression in yields (actual purchases by the ECB and various national banks began on March 9th). As the chart demonstrates, the largest yield compression has occurred in German bonds, where yields on 30-year maturities were 0.633% on Wednesday morning, down from 0.946% on March 5th. The spread between 2 and 30-year German bonds is currently 87 basis points. Yields for some of the riskiest longer-dated European debt (demonstrated here by Spanish and Italian bonds) have also seen compressions, though the spread between 2 and 30-year yields remains around 2%.

What does this mean for investors and the ECB bond buying program? Given the inverse relationship between bond yields and prices, the notable drop in yields has benefitted investors. However, reinvestment risk is a significant concern for investors should they sell their current holdings, as they would then have to purchase newer bonds that feature lower yields and coupons. Unless immediate cash is needed, bond investors will be loath to give up their higher yielding bonds in exchange for lower yields. Some wiggle room will be available as the front runners of QE look to cash in their profits, but others may hold out for a time since the ECB is a large, price indifferent buyer. Eventually, supply will normalize, possibly through a combination of profit taking and the ECB “nudging” those stubborn bondholders to sell.

Fragile Five Now Fragile Four?

In 2013, Brazil, India, Indonesia, South Africa, and Turkey were dubbed the “Fragile Five” due largely to high current account deficits and dependence on foreign capital flows. During the “Taper Tantrum”, these currencies were hardest hit recording double digit losses. This week’s chart provides an update on current account balances for each respective country.

In 2013, Brazil, India, Indonesia, South Africa, and Turkey were dubbed the “Fragile Five” due largely to high current account deficits and dependence on foreign capital flows. During the “Taper Tantrum,” these currencies were hardest hit recording double-digit losses. This week’s chart provides an update on current account balances for each respective country.

While the “Fragile Five” have been famously linked together, India has taken steps to distance itself from the group, improving its current account deficit from -5.1% in March 2013 to -1.3% in September of 2014. In addition, markets have praised the election of Narendra Modi as Prime Minister, given his focus on business confidence, economic growth, and structural reform. In sharp contrast, Brazil’s current account balance has declined and its political turmoil has heightened.

With the U.S. preparing to raise rates, emerging market participants are concerned about the possibility of a “Taper Tantrum” repeat. Relative to 2013, India is in a better position to handle such an environment. India’s contrasts with Brazil exemplify a growing trend of divergence within emerging markets, one that investors should expect to continue. Another tantrum will negatively impact the entire asset class, but some countries are better positioned to navigate the turbulence.