- With the economic outlook uncertain, the Fed appears poised to cut rates in 2019.
- The flat yield curve reconfirms that the U.S. economy is late cycle.
- Investors should prepare for rising market volatility and consider holding a high-quality fixed income portfolio.
- High yield has fared well, but elevated valuations mean this is not the time to add exposure.
- Municipals offer a favorable balance of credit quality, equity diversification and income.
Trade tensions have escalated, geopolitical risks have been rising and an increasing number of signals indicate the global economy could be losing steam. The Fed has responded with a dramatic turn in its policy, leading to a sharp rally in interest rates.
The benchmark 10-year Treasury yield dipped 72 basis points from its 2.79% peak in January to a low of 2.07% in early June. Market expectations now indicate interest rate cuts are coming. While trade disputes have dominated headlines, economic data has been weaker across the U.S., Europe and China. Industrial production has declined in China, falling to a 17-year low in early 2019.
Why the Fed pivot?
Just a year ago, the Fed appeared prepared to hike the fed funds rate well into 3% territory. But when equity volatility spiked in late 2018, monetary policymakers quickly changed their tune. The market expects the 2.5% fed funds rate established last year to be the peak for this cycle. What do we expect?
“It wasn't that long ago that the Fed was talking about three to four hikes in 2019, and now the market's pricing in two cuts in each of the next two years,” explains Mike Gitlin, head of fixed income at Capital Group.
The Fed’s dovish stance has spurred a broad-based rally across equities and credit assets. Central banks look to be taking a more aggressive tone on fighting against the next downturn, rather than merely accepting the inevitable.
Fed Chairman Jerome Powell implied as much earlier this month. He indicated that the Fed is ready to lower rates if economic indicators begin to deteriorate due to factors like trade disputes. “We are closely monitoring the implications of these developments for the U.S. economic outlook and, as always, we will act as appropriate to sustain the expansion,” he said.
The market appears to believe him: Following Powell’s comments, the 10-year Treasury yield dropped to a 20-month low.
Don’t be distracted by the yield curve.
One concern on investors’ minds is the yield curve. The spread between two- and 10-year Treasuries going negative — the curve inverting — often indicates economic stress or outright recession. Although the curve hasn’t inverted yet, it’s getting closer.
“With the Fed more open to rate cuts, and the possibility that tariffs could lift inflation, positioning portfolios for a steeper yield curve makes a lot of sense to me,” says Ritchie Tuazon, portfolio manager for American Funds Strategic Bond FundSM.
One catalyst may be in the corporate credit market. "Investors have been worried about rising interest rates for most of the last few years," says Pramod Atluri, portfolio manager for The Bond Fund of America®. “But the cycle has turned. In this part of the cycle exposure to interest rates can actually reduce volatility and preserve the value of an investor’s overall portfolio. Instead investors need to focus their attention on credit risk.
“For the last 10 years, companies have leveraged their balance sheets to make large acquisitions, buy back shares, increase their dividends and invest in their business," Atluri continues. "But when the credit market turns and the late cycle turns into a recession, some of these companies are going to find that their earnings stream won’t cover all the debt that they've issued. Investors who have been focused on interest rate risk and reached for higher yielding bond funds may find that their portfolios have large exposures to many of these companies.”
He adds that we’re facing an uncertain environment. “We don't know exactly what the next year or two will look like. With trade and the regulatory environment in flux, there will be winners and losers. And given today's rich valuations, investors are not being paid enough for the risks they are taking in many parts of the credit market.”
Keep an eye on other potential sources of risk in credit markets, including the possibility that a prominent U.S. telecom company could be facing a downgrade and that Italy’s fiscal woes could trigger a credit event, potentially sparking a selloff in European credits.
3 key implications for investors
1. Shore up your core.
In an environment of elevated geopolitical risks and a late-stage U.S. economy, ensuring a portfolio can withstand higher market volatility would be prudent. One approach is to upgrade the core bond portfolio allocation for better resilience in the face of equity volatility.
Research firm Morningstar took a step this year to help make this task a little easier when it decided to split its largest Intermediate-Term Bond category on the basis of credit risk. Those bond funds with less than 5% high yield were relabeled Intermediate Core, while those with more high yield now fall into the Intermediate Core-Plus category.
“This should clarify for end investors and for advisors that there are risks in the bond market. They need to be very aware of those risks,” Gitlin explains. “A core portfolio will provide diversification from equities, capital preservation, income and a measure of inflation protection. We refer to these functions as the four roles of fixed income in a balanced portfolio. The core portfolio should be able to provide that with much less volatility than you'll see from a core-plus fund.”
And remember, rates look more likely to fall than rise from here. That means a focus on limiting credit risk instead of worrying about interest rate risk probably makes more sense when evaluating a bond allocation.
2. Consider high income outside of high yield.
Of course, in a low rate environment income still matters — and it’s more challenging to come by. However, that doesn’t mean investors necessarily need to turn to expensive high-yield corporate bonds. Alternatives exist that can provide similar levels of after-tax income but less exposure to credit volatility: emerging markets debt and high-income municipal bonds.
“Emerging markets is a sector that I'd point to as a place that has really benefited from the Fed's pivot,” Atluri says. “Our analysts have found a lot of attractive opportunities in this asset class, which is relatively high quality compared to high-yield corporates.”
Trouble often hits emerging markets for idiosyncratic reasons and affects only a subset of countries. Deep credit research can therefore add value within the asset class. This allows fund managers to confidently pursue emerging market debt where economies have the strongest fundamentals and stable-to-declining debt trajectories.
3. Explore what munis could add to your portfolio.
High-income municipal bonds also present a very attractive after-tax income opportunity. They come with the added benefit of providing strong diversification to equities and higher credit quality than their high-yield corporate counterparts.
However, the value that munis offer goes beyond just their high income segment. You probably know munis are great for investors in the top tax bracket, but don’t fall into the trap of thinking they aren’t appropriate for anyone else.
The group of investors who can benefit from the tax-exempt nature of munis is bigger than most people think. Even those in more moderate tax brackets will have an advantage owning municipal bonds over their taxable counterparts. As the illustration below shows, anyone whose tax bracket is 24% or higher could earn nearly a quarter of a percentage point more yield by owning munis on an after-tax basis.
“There's an opportunity in munis,” Gitlin says. “For those who benefit from the tax-exempt nature of these bonds, they can get strong taxable equivalent yield without a lot of interest rate or credit risk.”
Although valuations are on the rich side for munis presently, investors looking to add exposure should consider waiting for market setbacks that could offer more attractive entry points.
Pramod Atluri is a fixed income portfolio manager with 20 years of investment industry experience. Prior to joining Capital in 2016, Pramod was a fixed income portfolio manager at Fidelity Investments and a management consultant at McKinsey & Company. He holds an MBA from Harvard and a bachelor’s in biological chemistry from the University of Chicago.
Mike Gitlin is head of fixed income at Capital Group. He has 25 years of investment experience, four with Capital. Mike was previously the head of fixed income and global head of trading for T. Rowe Price. He earned a bachelor's from Colgate University.
Ritchie Tuazon is a fixed income portfolio manager with 18 years of investment experience. Before joining Capital in 2011, Ritchie Ritchie traded TIPS, Treasuries and Interest Rate Swaps at Goldman Sachs. He holds an MBA from MIT, a master's in public administration from Harvard and a bachelor's from the University of California, Berkeley.
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Methodology for calculation of tax-equivalent yield:
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