Following the global financial crisis (GFC), central banks enacted an intensive program of monetary easing that pushed down U.S. policy rates to a near-zero target. While ultralow interest rates helped markets to snap back from the GFC, they also created some difficulties. Banks grappled with scant net interest margins, pension funds struggled to grow their assets to satisfy liability needs and individuals experienced a wealth effect that improved real estate and equity prices but also increased inequality. Over time, market participants grew weary of the low yields available in markets and the broad imbalances created by aggressive monetary policies. Also, investors and market experts have increasingly adopted the perspective that monetary policy has run its course, and further rate cuts or QE will not necessarily move the needle on a country's economic growth.
At the same time, economic globalization and rapid changes to traditional systems of commerce and wealth building have prompted significant shifts in labor needs and income equality. This has created fault lines in the contentment of voters and helped spawn a rise in populism. Earlier this month, President-elect Donald Trump rode this populism wave to victory. His platform included a wide array of policy changes meant to accelerate the U.S. economy, such as tax cuts, heightened trade barriers and up to $1 trillion in new infrastructure spending. Thus far, the U.S. equity market seems to be welcoming these proposals. However, the long end of the Treasury curve has risen sharply since the election partly due to the potential inflationary pressures created by each of these policies. Tax cuts and infrastructure spending are fiscal policies that could lift wages and prices, while trade barriers – especially in the company of a clampdown on immigration could boost the price of goods, reduce the labor force and drive up wages.
Over the long run, populism is not a movement that's friendly to bond investors. In our view, the post-election sell-off in Treasury bonds is a trenchant example of a broad repricing that reflects trends evident even before the election and that now have gathered steam. Adding to the upward pressure on rates has been reduced monetary policy support for long-end bonds and China’s sales of U.S. Treasuries. We believe it's likely that we have reached a turning point in the bond bull market of the past 34 years. Investors must now adjust to a new world order in which, for the foreseeable future, the path of least resistance for interest rates is no longer down, but up.
Rising rates are not solely good or bad for fixed income market participants. Like most trends in financial markets, rising rates have good and bad elements, and much depends on the positioning and time horizon of the investor.
The bad news of rising rates is, of course, that bond prices will fall. With yields still at low levels, even a modest drop in bond prices will likely result in a negative total return for most bond portfolios. This will represent a reversal of the general trend of the past 34 years, during which progressively lower interest rates produced favorable total return results and these results, in turn, attracted more investors into fixed income assets. The risk is now that rising rates will lead to a reversal of those flows. A protracted period of sales and redemptions out of ETFs and bond funds could prove to be very disruptive, especially considering diminished liquidity of fixed income markets.
Those who invest in bonds directly versus through an ETF or bond fund should be better positioned to weather any storm in fixed income. While the bond market may suffer some volatility, the cash flow from a portfolio of high-quality bonds should remain predictable and reliable. If a bond portfolio is properly structured to align with an investor's risk tolerances and liquidity needs, then its cash flow offers a return independent of the market – including a return of principal. In this way, a bond portfolio can offer a haven from market dislocation and thus a more effective counterbalance to risk assets such as equities.
It is important, as well, to recognize the good news of higher rates. Keep in mind that, over time, rising rates can lead to increased income for investors who maintain a long-term investment horizon. These investors can, in time, benefit from an increase in yields, because they can reinvest at higher rates as holdings mature or short-term bonds are sold. Importantly, this requires a well-structured portfolio with diversified maturities that allow investors to reinvest periodically as rates tick higher. With attentive management, such portfolios could be poised to benefit as the long-awaited upturn in yield begins to surface and opportunities to build income arise.
We invite investors and advisors to engage with us on the broad changes occurring in fixed income markets. As we look forward, investors who have attempted to time the market will indeed face a tough road, as they are focused on short-term performance and market returns rather than cash flow returns. However, we think that as the FOMC begins to place upward pressure on rates and we approach a more normalized yield curve, momentum away from yield repression can create opportunities for the long-term investor.
DISCLAIMER: The material in this document is prepared for our clients and other interested parties and contains the opinions of Breckinridge Capital Advisors. Nothing in this document should be construed or relied upon as legal or financial advice. Any specific securities or portfolio characteristics listed above are for illustrative purposes and example only. They may not reflect actual investments in a client portfolio. All investments involve risk including loss of principal. An investor should consult with an investment professional before making any investment decisions. This document may contain material directly taken from unaffiliated third party sources, including but not limited to federal and various state and local government documents, official financial reports, academic articles, and other public materials. If third party material is included, it is believed to be accurate, and reliable. However, none of the third party information should be relied upon without independent verification. All information contained in this document is current as of the date(s) indicated, and is subject to change without notice. No assurance can be given that any forward looking statements or estimates will prove accurate or profitable.