“It’s true that the Federal Reserve faces a lot of political pressure and is unpopular in many circles”
Since the financial crisis, the Federal Reserve has been faced with difficult monetary policy decisions, often resulting in backlash from investors, politicians, and many other observers. From 2008 to 2015, the Fed kept interest rates at zero, in order to minimize interest costs and promote lending with the ultimate goal of boosting economic growth. Corporations have benefited from easy credit, which they have mostly used to buy back shares, or conduct mergers and acquisitions. For consumers, it has been a mixed bag, as auto loans and mortgages have been inexpensive, but on the other hand money markets and short-term bond yields have provided paltry amounts of income. Historically low bond yields have effectively forced investors to take on greater stock market risk in order to generate better returns.
As economic conditions have improved over the last few years, the Fed begun the process of raising interest rates, starting with just one rate hike in both 2015 and 2016, and three rate hikes in 2017. The Fed’s primary goal with raising rates has been to head off excess risk taking, control the amount of leverage in the system, and ultimately prevent the economy from overheating. At their March meeting of this year, the Fed raised rates to 1.75% and they are widely expected to raise them again in their June meeting. Barring any major economic surprises, they will likely hike once or twice more this year, with interest rates ending the year at 2.50%.
While most of the financial media attention this year has focused on volatility within the stock market, the poor performance across the bond market has largely gone unnoticed. The Barclays Aggregate Bond Index, a widely referenced benchmark for high quality bonds, has fallen 1.90% through the first five months of the year, on pace for its worst calendar year return since the 1960s. Corporate bonds have fared worse, with the iShares Investment Grade Bond ETF (LQD) falling 3.88%, YTD, as of the end of May.
As more attractive yields have surfaced in the fixed income universe, thanks to the rising interest rate environment, bonds issued a few years ago with lower coupons have lost their luster and their prices have fallen as a result. Yet the sell-off in bonds has received little media attention for two reasons: 1) Bonds are boring for the most part. Unlike buying Netflix stock, there is no double-your-money potential payoff when you buy a U.S. Treasury bond. 2) A bad year in bonds is nowhere near as significant as a bad year in stocks. We noted that, if current trends continue, this would be the worst year for bonds in nearly 5 decades. Yet, if the Barclays Aggregate Bond Index ends the year down 3.5%, that is only one tenth the decline that the stock market experienced in 2008 when the S&P 500 fell 36%. 18 of the last 20 calendar years have seen the Barclays Agg deliver positive returns for investors.
So where are we going with all the boring bond banter? We want to highlight the widespread negative returns across fixed income markets because they have been a detractor across any diversified portfolio this year. The one exception of positive bond returns has been in the floating rate sector, which we have noted as a key fixed income overweight in our portfolios due to their low interest rate sensitivity and attractive yields. It is also important to iterate that short-term negative returns in the fixed income market are also leading to more attractive long-term return opportunities going forward. The immediate discomfort leads to the payoff of better income in the future. The chart below illustrates that when Treasury yields have risen quickly, the following twelve month returns for municipal bonds were generally very strong.
Corporate bonds have also shown the propensity to bounce back after a bout of weak returns like they are experiencing this year. The last time corporate bonds fell more than 2% in a calendar year (2013), they returned 8% the following year.
As interest rates rise, and the U.S. economic cycle continues to age, there will be greater opportunities in fixed income markets over equity markets, which we will actively position towards in our portfolios. Though the Federal Reserve may not be popular with bond investors in the short-term, as they raise interest rates, the long-term positives will flow through via higher income, better valuations, and ultimately stronger total returns for investors.
Investment advisory services offered through Independent Financial Partners, a Registered Investment Adviser
WhartonHill Investment Advisory is not owned or controlled by Independent Financial Partners
The opinions voiced in this material are for general information only and are not intended to provide specific investment advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing.
All data via Morningstar, Bloomberg, and the Wall Street Journal.