The Fed Forecast
What will interest rates do? Who really knows? The answer to that question is important to the US economy, the equity markets and especially the fixed income markets. Many have a thoughtful hypothesis, but who can forecast the future?
In our KnowRisk(SM) Commentary from December 2012, The Warning Label, we stated that interest rates “according to the Federal Reserve, should remain low through 2015. After that, according to Warren Buffett, the billionaire chairman of Berkshire Hathaway Inc. it may be difficult for interest rates and inflation to remain low.” As we have seen so far, this is pretty close to the current consensus, but what about going forward?
The members and staff of the Federal Reserve Board Open Market Committee (FOMC) should have an idea, since they are the group who actually make the decision and set the short term federal funds rate. They nailed it in 2013 with a unanimous agreement of 25 basis points.
As you move out in time, the opinions start to vary but generally move up as noted in the graph above. The median of the group is still at 25 basis points for all of 2014, moving to 75 basis points for 2015, and out to 175 basis points for 2016 (although with a wide dispersion of opinions from 50 to 425 basis points). The “Longer Run” which goes out past 2016 is a fairly tight consensus of a 400 basis point Federal Funds rate.
To further look into the future, we looked into the futures. Futures contracts are the vehicle through which large sophisticated institutional investors are investing billions of dollars into future purchases of bonds out one, three, and five years into the future. The results seem to concur with the opinions of the Federal Reserve Board members.
The Barclays Aggregate bond index is a common gage for the broad fixed come markets, like the S&P500 is for stock. It is comprised of Treasury, mortgage, and corporate bonds. One of the reasons that the duration of the Barclays Aggregate index is longer than average today is the low level of yields and the higher allocation to US Treasury bonds. This silent change means higher risk and lower return for what has traditionally been considered a low risk asset.
There is a tradeoff between the two main risks of fixed income investing: duration risk and credit risk. Duration risk is the effect of interest rate changes on bond prices. Credit risk is the risk of default. In the current environment, the probability and magnitude of the duration risk is perceived as being much higher that the probability and magnitude of credit risk.
Duration is the calculation of the interest rate sensitivity of a bond, and it changes as interest rates change. Bond duration of 9 years, means that for every 1% rise of interest rates, that bond will decline in value by 9%. Mathematically, as yield goes up on a fixed-rate, fixed-maturity bond, duration goes down due to having higher coupon payments throughout the loan in proportion to the face value which is returned at maturity (and vice versa). Mortgage bond durations decline as yields decline but can really shoot up in rising rate environments (due to slower refinance speed). This makes duration risk a moving target. The following graph shows the effect on duration since 1985 for a 10 year US Treasury bond. As rates went down from 12% to 2%, duration went up from 5 years to 9 years.
This makes it a tough environment for fixed income investments. If you take the same results indicated from the Fed forecast and the futures market, and assume a monthly change of US Treasury rates to the forward target rates, you get a result for the fixed income markets as shown on the next graph. These are seven of the major indexes from Barclays. All but one is flat to negative for the next three years, and the rest of the group returns only a 0.35% to 1.09% annualized performance for the next five years. This will be a disappointing result for investors looking for the traditional low volatility, high interest return from bonds. The short term high yield index is the only one which shows results similar to what bond investors have enjoyed for the last 30 years, but high yield (lower quality) bonds carry more credit risk for investors to take into account. The solution does not appear to be in most of these indexes and may lie outside of the traditional approach to bonds.
This research shows that the indexes for traditional fixed income may have a stiff headwind from rising rates and a difficult time protecting capital and making money. If the Fed’s forecast is right, most of the fixed income indexes are dead in the water for the next 5 years! If there was a multiyear bear market coming in the stock market, equity managers would be jumping up and down. The bond firms generally appear flat footed. Since interest rates have been falling for 30 years, most of the current bond portfolio managers have no experience in this environment. Pimco just replaced their CEO and the Portfolio Manager for their unconstrained product. Bill Gross is taking over this product personally.
The Barclays Aggregate represents roughly 35% of the investable fixed-income universe. The remaining 65% includes below investment grade, floating rate, and non-US bonds. All of these assets are less correlated to US Treasuries and many of them have higher yields. Again, as we mentioned in the previous KnowRisk(SM): “Managers with the ability to adapt to change, with the ability to manage portfolio risk factors such as yield, duration, allocation weighting, and credit quality, can find success in multiple environments.” Unfortunately few do.
The future, at least the next 4-5 years of the future, may be in actively managing bonds outside the basic traditional domestic aggregate through actively utilizing all the fixed income components and with global diversification. There are a few managers who have adopted an “unconstrained” fixed income policy for this purpose. These managers search for yield while reducing the duration risk in different ways. Some assume more credit risk, while others keep the portfolio quality investment grade. Some raise large amounts of cash, while others short Treasury Bonds. Floating rate bonds are not ideal in a falling rate environment, but may be helpful in a flat to rising rate scenario. Because of the nature of the floating coupon rate, these types of bonds may have a duration risk approaching zero.
Some of the managers we have researched in this investment style include: Alliance Bernstein Unconstrained Bond (AGLIX), MainStay Unconstrained Bond (MSDIX), Metropolitan West Unconstrained Bond (MWCIX), Pimco Unconstrained Bond (PFIUX), and Western Asset Total Return Unconstrained (WAARX). It is important to know, and to be comfortable with the techniques the managers’ employ to address the current fixed income environment, so talk to a professional investment management consultant before investing.