Written by: Derek Majkowski. Any opinions are those of Derek Majkowski and not necessarily those of RJFS or Raymond James.
With the recent announcement by the FOMC to raise target interest rates for the second time in 3 months, and the expectations of further gradual hikes over the course of the year. We thought it might make sense to discuss bonds and fixed income allocations within a portfolio.
Since July of 2016, we have seen the 10 year US Treasury Bond yield move from just under 1.4% to over 2.6% in this past week. The general shift from accommodative FED policy to one of tightening has caused us over the past several months to be a bit cautious with allocating too many funds toward fixed income investments.
It has been over a decade since we have seen consecutive interest rate hikes, and the recent moves have been described as a “normalization” of interest rates from extraordinary low historic levels. Without having any real idea on where interest rates will settle and when, it is hard to predict the impact on bond and fixed income prices when we see rates moving higher from these historically lower levels.
One of the tools used by the Federal Reserve to support our economy and drive economic activity following the financial crisis in 2008 was lowering Fed Fund interest rates to virtually 0%. This in addition to quantitative easing, were dramatic actions taken to attempt to re-inflate prices and jump start the economy. After several years, we saw this monetary easing reverse, coincided with a stock market rally and pause, and economic activity modestly improving at a sluggish pace.
Fast forward to today, and as mentioned above, we have seen a sizeable move in the 10 year US Treasury Bond yield, and a stock market that has moved up fairly quickly. The move in both are being pegged to the prospects of pro-business, pro-growth policies from the newly elected government, and the prospects of less regulation, lower tax rates, and potential infrastructure spending and fiscal stimulus.
Will this trend in stock market prices and interest rate yields continue moving higher?
Who knows? The accommodative monetary policies not just in the US but also around the world, have attempted to ignite economic activity and stimulate price appreciation and the overall wealth effect. Until recent – July of 2016 – interest rates remained historically low and bonds and fixed income prices remained high.
In the past several months however, we are seeing a shift that we have not seen in several years, and the vulnerability in portfolios have come from the drop in prices in bonds, bond funds, and interest rate sensitive securities. Portions of the portfolio that many investors have long considered conservative investments or primarily held for income, are seeing more price swings and volatility. This is not typically the case, or it hasn’t been the case for quite some time.
After years of predictable and favorable returns in bonds and bond funds, it has been a while since we have seen prices in this group go down. It is also why we are spending a lot of time identifying some of the potential risks and vulnerabilities within portfolios with this asset class.
How do you prepare for a reversal from extreme accommodative measures that used the purchasing of bonds / fixed income and very low interest rates as a catalyst? What will the reverse, or normalization of the exercise look like, and how will it impact the pricing on debt? Will the FED be able to operate gradually, or will economic activity heat up too quickly and increase inflationary pressures that forces the Federal Reserve’s hand?
We recognize we have no more idea on where interest rates will settle out as we know where the stock market will be from one day to the next. What we do know however given our experience, is that extreme behavior has a tendency to snap back to the mean.
According to FedPrimeRate.com (http://www.fedprimerate.com/fedfundsrate/federal_funds_rate_history.htm), since 1990 and prior to the 2008 financial crisis, the Fed Funds Rate ranged from a high yield of approximately 8.25% to a low yield of approximately 1% in 2003. At the end of 2007 the Fed Funds Rate sat at 4.25%.
In 2008, the Fed Funds Rate saw a high in January of 3.5%, and by December of 2008 the rate was at 0-.25%. We did not see another move up until December of 2015, where the rate went to .25%-.50%. Since then the FOMC has moved the rate up to a .75%-1% rate.
Which is the right place for rates to settle? Will it be the range that we saw from 1990 to 2007, or more like that we have experienced since 2008?
That is the question that we are contemplating with many clients and colleagues, and that is why we want to make sure we review all of the potential risks and pitfalls that one could face in an environment that we have not participated with in quite some time. When there is a traditional sense and expectation with investing in bonds and fixed income, notably consistent income and some stability and safety; we want to make sure investors are prepared for the potential ride they may be jumping on if the interest rate landscape “normalizes” from such abnormal historic levels.
This information does not purport to be a complete description of the securities, markets, or developments referred to in this material; it has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. This information is not intended as a solicitation or an offer to buy, sell, or hold any security referred to herein. Investing involves risk, investors may incur a profit or loss regardless of the strategy or strategies employed. There is an inverse relationship between interest rate movements and bond prices. Generally, when interest rates rise, bond prices fall and when interest rates fall, bond prices generally rise. The third party link provided has been included for informational purposes only. Raymond James is not affiliated with and does not endorse, authorize or sponsor the listed website or their respective sponsors. Raymond James is not responsible for the content of any website or the collection or use of information regarding any website's users and/or members.