For bonds, a change in the weather?

Fixed income opportunities exist as interest rates rise and stocks turn volatile.

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Key takeaways

  • The Federal Reserve is likely to raise rates once more in 2018, but the end of the current cycle of rate hikes may be approaching.
  • The bond market is beginning to price in the potential for higher inflation, muting the appeal of inflation-linked Treasury securities.
  • Fundamentals remain strong for high-yield bonds and leveraged loans.

In the decade since the global financial crisis, the investment climate has been notable for how little it has changed. Central banks have kept interest rates low and liquidity abundant, and fixed income yields have remained modest by historical standards while major stock indexes have risen steadily. But while the US economy's decade-long expansion continues, steady stock markets have given way to volatility and fixed income yields are rising as the Federal Reserve continues to raise rates. Recently, Viewpoints spoke with Chris Pariseault, CFA®, Fidelity's Head of Fixed Income and Global Asset Allocation Institutional Portfolio Managers, about these changes in market conditions and what investors might expect next.

Will more volatile equity markets and higher yields push investors out of stocks and toward fixed income?

Pariseault: Sure, some of the volatility in the equity market may spill over into demand for bonds, especially among Treasuries. But investors should remember that a little adjustment isn’t out of the ordinary after the equity markets have climbed for a while.

Is the US economy still in good shape?

Pariseault: The economy continues to grow at a very strong pace. The latest figures put unemployment at 3.7%—the lowest level since the late 1960s—and we continue to see strong economic growth in the US compared to the rest of the world. Corporate balance sheets are very strong. New tax rules have given companies tax cuts and spurred them to bring cash back to the US from overseas.

A few risk factors to watch out for over the next few quarters include the shrinking tailwind from tax cuts, less cash coming in from overseas, and tighter credit conditions. All 3 can contribute to reduced economic activity and that could be meaningful as we continue to teeter between the middle and late stages of the economic cycle.

Are companies using that extra cash to pay down debt?

Pariseault: The expectation was that liquidity would drive down corporate debt levels. While debt has declined a bit, corporations have still issued more than a trillion dollars in investment-grade bonds so far this year. The fundamental backdrop has remained extremely strong. Earnings for investment-grade and high-yield issuers alike have been very healthy, in financials as well as industrials and utilities. Banks in particular have enjoyed strong balance sheets and higher net interest margins from rising rates.

The Fed's September rate hike drew criticism from the White House. Will that have any effect on the Fed’s future interest rate policy?

Pariseault: I don't think comments from President Trump will change what the Fed will do. I think the administration is cheering the fact that the stock market has done well and rising interest rates typically put the brakes on a rallying stock market. At this point, 

I expect to see another move by the Fed in December. The Fed has telegraphed its intentions and has presided over a very orderly tightening of monetary policy. Fed Chair Jerome Powell is continuing where his predecessor Janet Yellen left off.

Moving forward, however, the end may be in sight. One central banker recently suggested that the Fed may put the brakes on rate hikes once the federal funds rate reaches its 3.25-3.50% target range—assuming that the economy remains healthy, of course. For bond investors, that means the risk posed by rising rates may not be as one-sided as it was just a few years ago.

What can investors learn from the shape of the yield curve?

Pariseault: The yield curve is flat—in fact, the difference in yield between the 2-year and 30-year Treasuries is just 48 basis points. In a more normal curve, the spread between 2- and 30-year bonds might be more than 200 basis points. In this environment, I think it’s prudent for a bond investor—whether they're investing in Treasuries or corporate bonds—to stay within the 2- to 10-year range and they may even want to focus more narrowly on bonds between 4 and 8 years.

We could see an inverted yield curve in some scenarios, where the Fed keeps tightening, which would push down yields and potentially invert the curve. Even that probably wouldn't stop the Fed from raising rates, though. There are historical instances when the Fed continued to raise rates despite an inverted curve. Although an inverted yield curve often signals a recession, I believe the US is probably a few years away from the next recession.

Where are you seeing opportunities in the fixed income market?

Pariseault: I see Treasuries as an opportunity for investors. We've already seen a big move up in yields, so there's less risk of negative price return from rising rates. So investors who seek stability shouldn’t be scared of Treasuries.

For more risk-tolerant investors, the high-yield market can offer some appeal. The fundamental backdrop is strong and the risks are fairly benign. Defaults aren’t rising and yields are attractive: Spreads have largely stayed unchanged as rates have risen. Leveraged loans may also continue to offer good value. However, it is important to ensure that they have adequate covenant protection.

Are you avoiding particular parts of the market?

Pariseault: Treasury inflation-protected securities have become more fairly valued. I think up until a few months ago the market was underappreciating the potential impact of inflation. As rising interest rates and higher wages start to affect their earnings, corporations may have to raise prices. That's when inflation may start to take hold more strongly. The Fed is certainly paying close attention to that dynamic. Now the market is starting to appreciate the fact that inflation could be an issue.

Investors also should be cautious with emerging market debt. It’s really a bond-by-bond situation in those markets; you have to be careful to avoid some of the problem credits.

Next steps to consider

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