- Rising growth and inflation expectations have led rates to rise sharply in recent months.
- Comments from new Fed chairman Jerome Powell appear to have caused investors to adjust their expectations.
- Bond investors should expect headwinds, and may want to review the rate risk in their portfolio.
As stocks continued to hit record highs in January and February, bonds suffered. Prices fell as yields spiked between December and mid-February. Add in a new Federal Reserve Board chairman, and bond investors likely have questions—and some anxiety—about where the bond market is heading.
Viewpoints caught up with Tom DeMarco, CFA®, a market strategist in Fidelity Capital Markets' fixed income division. Here he shares his thoughts on Fed chairman Jerome Powell, how bond investors can respond to a more volatile market, and which areas of the fixed income markets look appealing in this rising-rate environment.
How has Powell's takeover as chair of the Federal Reserve impacted the market?
DeMarco: Powell testified to the House Financial Services Committee in late February, and his comments caused some market indigestion. Investors interpreted Powell's testimony as a signal that the Fed would be somewhat more hawkish and raise interest rates 4 times this year, and some have even called for 5 rate hikes. Late last year, the market was pricing in 2 to 3 rate hikes in 2018. Coming into 2018, I thought the Fed would raise rates 3 times this year; since then, a combination of economic data and fiscal policy has me leaning to 4 hikes.
Along with the tax bill, the latest government spending bill, which was signed by President Trump in early February, is likely to boost economic growth in 2018 and 2019. That growth may prolong the cycle we're in. One caveat to all this is the current threat of tariffs and any expansion into a global trade war.
I think we're going to have to get used to volatility again after a long stretch of abnormally calm markets. We're likely to see more frequent swings in both the equity and fixed income markets. But, quite frankly, those are signs of normality. Meanwhile, a number of factors—including demographic trends, globalization, and technology—are helping the Fed maintain a more gradual increase in interest rates without having to step hard on the brakes.
Bond yields have moved sharply higher this year. Should bond investors be worried?
DeMarco: I think they do have cause to be anxious. We're near historic lows on interest rates, and the next major move is likely going to be up. And while there's plenty of evidence that suggests equities are overvalued, investors need to be cognizant that there are some signs that the secular bull market in fixed income may be over.
In my personal opinion, there are a number of factors that could argue for a long-term change in fixed income trends:
- The Fed and the ECB (and relatively soon, the Bank of Japan) are all removing accommodative policy.
- The US faces a deteriorating fiscal position courtesy of tax reform and increased government spending at the peak of the cycle, which could result in significant budget deficits and a large projected increase in Treasury supply.
- There are stirrings of inflation, along with the realization that the Phillips curve, which describes a connection between inflation and employment, may finally be coming back into relevance.
How might investors respond to that?
DeMarco: One action investors can take is to review their duration risk to make sure it matches their risk tolerance. In a rising-rate environment, one strategy I have used is a laddered portfolio structure that holds bonds with maturities across the yield curve. Floating-rate or inflation-linked securities may also be appealing.
You expect that increased spending and other factors will boost economic growth. Are there parts of the bond market that can benefit from that growth?
DeMarco: That growth is certainly good for corporate America. Spreads are still tight between corporate bonds and Treasuries, however, so finding opportunities will require digging into individual names. There are sectors that look appealing, but investors should have lower expectations for performance. And one variable is volatility: If volatility settles down some (and it has since the February spike), then high-yield bonds could produce coupon-like returns. But if volatility is jumpier, investment-grade bonds may be a place for investors to gravitate. One thing that was interesting during the volatility spike in early February was how well-behaved corporate bonds were from a spread perspective. I had thought that either volatility would recede or spreads would jump higher; so far, it has been the former.
What areas of the corporate bond market look attractive?
DeMarco: Industries such as paper and packaging, life insurance, pipelines, and metals and mining look attractive. In regards to banking, the industry deregulation that’s being discussed in Washington wouldn't necessarily be positive for bond holders, but it shouldn't cause worries in the short term. The aerospace and defense industries looks interesting, primarily due to higher defense budgets in the latest spending bill.
On the curve, I note that the 2- to 3-year part of the corporate curve has cheapened noticeably on a spread basis from the beginning of the year, due primarily to selling by corporate cash accounts and overseas accounts. The influx of bonds and the fact that dealers had limited appetite to hold this paper for long led to 2- to 3-year high-grade corporate bonds cheapening about 10–15 basis points (bps) generally and more like 25 bps for large, frequent issuers. We are seeing yield-to-worst in this part of the market of over 3% in some cases. So this seems to offer better relative value in my opinion than it did only a couple of months back, and of course is still defensive from a duration perspective.
In terms of credit quality, I still find valuations on the rich side among BB-rated issues compared to BBB-rated securities, which are considered investment grade. As a result, I'm gravitating toward B-rated issues rather than BB-rated bonds in the high-yield space. Within investment grade, BBBs look nominally cheaper vs. higher ratings.
Are there sectors you're avoiding?
DeMarco: I have concerns about the automobile industry and the broader retail industry, though I am OK with the discount stores and offline retail. The tax reform measures that passed in Washington require utilities to pass along any savings they receive from lower taxes directly to ratepayers. As a result, bond holders won’t benefit from increased cash flows resulting from a smaller tax bill unless companies issue equity to offset those payments. Valuations in the technology sector remain rich, and while some pharmaceutical names offer appeal, I’m cautious on the whole sector due to comments from lawmakers about reducing drug prices.
What are you seeing in the municipal bond market?
DeMarco: Investors are waiting for supply to pick up in the muni market. There was a surge of issuance at the end of 2017, in part because municipalities raced to sell bonds before new tax rules took effect. But issuance all but dried up as the calendar turned to 2018—through the end of February issuance was down 47% year-over-year. There are some concerns that a surge in supply would cause a further sell-off in the muni bond market, but I expect that any increase in supply would be met with strong demand from investors. We have a low supply forecast for 2018 of around $290 billion and we are not far from the peak redemption months of June to August which should see about $120 billion needing reinvestment. And the muni market’s net supply is still in negative territory, which is providing a good technical tailwind.
Are there areas of the muni market that look attractive?
DeMarco: In the muni market, investors may want to consider very high-quality general obligation bonds issued by states and municipalities that aren't facing pension issues. There is also appeal in essential service bonds used to fund airport and power projects. I'm cautious on the hospital sector and long taxable muni sector (they look rich compared to long high-grade corporate bonds). I also think investors may want to consider more defensive coupons like 5% to help cushion against potential de minimis issues and duration risk.
Municipal bonds at the long end of the yield curve are more attractively valued than those at the short end. The ratio of yields on long-term munis to Treasury yields is in the high 90% range, making longer-term muni bonds very attractive relative to Treasuries. But the long end of the yield curve may not be appropriate for retail investors because of the considerable duration risk as rates move higher.
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