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Investing Podcast recorded on September 26, 2016

Eye on the FOMC: Strategies for the Current Yield Environment

Podcast Transcript

Hello, this is Natalie Wright, Product Manager at Breckinridge and welcome to the Breckinridge podcast. Today, I am joined by Breckinridge's Chief Investment Officer, David Madigan, and the topic is "Eye on the FOMC: Strategies for the Current Rate Environment". So two big Central Bank meetings have occurred this week. On Wednesday, the Fed kept rates on hold, which was in line with market expectations and now the marketplace places a roughly 57% probability on a December rate hike, about unchanged from before the meeting on Wednesday. The Bank of Japan also met and they refrained from further easing but they did announce new efforts to control the yield curve, similar to what the Fed did in the 1940s. For more detail on the market's reaction to the central bank announcements this week, please listen to our weekly market commentary.

A quick disclaimer from our Compliance team. Keep in mind that what we are providing in this podcast is general information and not specific advice for any particular investor. All investors should consult with their financial professionals before making any investment decisions as all investments involve risks and could result in loss of principal.

Market participants have been closely watching Central Banks to learn about the potential path of rates for the rest of the year. So David, let's start with what happened so far this year.

Well, year-to-date the treasury curve has bull flattened, meaning that short-term rates have remained about flat and long-term rates have lowered. This has been an ongoing trend resulting from the lower from longer posture from a significant demand on the long end of the treasury curve. The long end demand is coming from foreign investors who are looking for both yield and the best place on the curve to invest their foreign-exchange dollar funding cost. However, in recent weeks, the treasury curve has steepened due to a potential shifting of central bank support away from the long end of the curve. In addition, some disappointing data prints throughout the month such as payrolls and retail sales have lowered expectations for a rate hike, keeping front-end yields anchored. In muni bonds, the long-term curve flattening trend has been in place since the end of 2013, but similar to treasuries, the curve has been steepening in recent weeks due to some pressure on the long end. In corporate bonds, the curve remains relatively steep.

Okay, and if you think about strategies for the current environment, looking forward, if you think rates will rise in the future, what is the concern and what are some options for positioning?

For fixed income investors, the main concern is duration risk, which means the risk of rising rates. If investors think that the Fed will lift rates in the next six months, they may be concerned about their longer holdings taking a bigger hit as rates rise. This may not be the case as rising short-term rates may move the market to a risk off trade, meaning that concern about future inflation diminishes and so longer term rates actually remain fairly low. At the shorter end of the curve, rate movements are not as impactful to price so the belly of the curve, which is the 5 to 7 year portion, is also typically hurt most when short-term policy rates are increased. An option for this risk is to move to our short or limited term strategies to reduce the exposure to duration. However, investors should be mindful that there is a shorter end of the curve that are also collecting lower income from coupon payments. An alternative is a more barbelled structure where portfolios are concentrated in 0 to 3 year area, and in bonds closer to the strategy maximum so that investors can also collect larger coupon payments and income payments from longer maturity bonds. Moving to a barbelled portfolio structure will under-perform, though, if the yield curve steepens as inflation risk increases.

Okay, well, what about investors who are more in the lower for longer camp and think that the Fed won't move toward any further rate normalization in the next six months or so?

As fits with our current strategy that we have implemented in our portfolios, these investors may want to remain neutral. Currently, the market is priced for a stable FOMC policy with less than 60% chance of rates rising in December. Rates will remain volatile as the outcome of this policy may stimulate demand or concern about inflation going forward.

What about the yield curve? What options are available if you think the curve is going to flatten further?

Well, if an investor believes that the curve will bear flatten, which means that the short end will rise more than the long end, they may not want to focus on the intermediate part of the curve. If an investor thinks that the curve will bull flatten where the long end falls more than the short end, a longer duration portfolio similar to our Long-Intermediate Tax Efficient or Gov-Credit strategies is a better option.

Okay, and does Breckinridge's investment committee have any views on the curve that you can share?

Well, in our view, the curve isn't likely to flatten further, unless a recession occurs. Our current outlook is for continued slow growth and we're neutral to the yield curve in both our long and intermediate strategies.

So are there any differences in the curves for the municipal and corporate sectors?

Yes, some sectors are typically steeper or flatter based on where they tend to issue debt. Also, the concentration of maturities for corporate and municipal issuance often changes. For example, so far this year, high-grade corporate issuance has been more in the belly of the curve. The same could be said of municipals over the last year where more refunding issues have been in the belly of the curve.

Okay, and what about some of the risks to think about when deciding how to position?

Several uncertainties are out there. The first is the Fed path is uncertain and the market is continuously reassessing when the Fed will increase rates. Globally, central banks are using unpredictable policies to stimulate their economies in an era of slow or sluggish growth. In addition, the short end of the municipal and corporate bonds are under scrutiny due to the new money market fund rules going into effect in October, which may further prompt outflows as the market digests these new rules. On the corporate side, investors should, of course, be mindful of credit risk in corporate bonds. For example, we are positioned shorter than the Barclay's Gov-Credit Index because our credit risk is higher due to a higher allocation to corporates that are outlooked for higher rates over the next 12 to 14 months. However, we focus on high-quality bonds and perform in-depth bottom-up research to choose and monitor our holdings.

Well, we don't necessarily want to make allocation decisions for our clients, but is there any reason to stay in fixed income at all, even with rates potentially rising?

Remember that as rates go up, investors are getting more income as coupons and principal repayments are reinvested. Our goal at Breckinridge is always capital preservation and a high-quality fixed income portfolio can offer clients a counterbalance to the volatility in the broader market.

Okay, thanks David. We hope that you in the field have found this informative and we look forward to you joining us on our next podcast. Thank you.


DISCLAIMER: The material in this transcript is prepared for our clients and other interested parties and contains the opinions of Breckinridge Capital Advisors. Portions of this transcript may have been edited from the original podcast recording to improve clarity of message. Nothing in this transcript 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 & 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.