PM Perspectives: Rising Rates, Widening Spreads Challenge Fixed Income Investors
John Lloyd, Janus Henderson’s Co-Head of Credit Research, says generating a positive return in fixed income gets harder as global rates rise and as the premium investors demand to hold investment-grade and high-yield bonds over Treasurys of similar maturities widens.
- Global rates will likely continue to rise, led by the U.S. Federal Reserve’s strategy of removing liquidity by ending quantitative easing and raising interest rates, with two or three more hikes expected this year and more to follow in 2019
- Inflation is returning, with oil surging, other commodity and raw material prices rising, and wage growth accelerating as unemployment falls below 4% in the U.S., creating headwinds for fixed income investors
- With rates rising and spreads widening from historically tight levels, shortening duration and limiting spread risk is one strategy that fixed income investors might consider to preserve capital and attempt to produce positive returns
We’re cautious in the credit cycle right now for a couple reasons. One is rising interest rates and the other thing we are worried about is the spread premium that you get for investing in a non-risk-free Treasury.
I think rates will continue to move up in the market for a couple of reasons. One, the Fed is draining liquidity. We expect the European Central Bank to do that as well. So global rates will be going up. Also, there are technicals in the markets globally, as global rates rise and the hedging costs in the U.S. increase, you are seeing less money flow in from Europe and Asia that is investing in the U.S. market. That will also make rates rise. We are also seeing inflation pick up, you know, oil prices are up year-over-year, raw material goods have been up, housing, there is a shortage of housing in the U.S. and you have seen housing prices that are up in the mid-single-digits on a year-on-year basis. And then wage inflation, we expect that to continue to start flowing through as the unemployment rate is now under 4%. So the first component of that is we do think we are going to see pressure on rates over time and as you are seeing that pressure on rates, you are seeing people kind of generally exit or reallocate a little bit more money out of fixed income and that is also affecting the spread that you get on top of the risk-free Treasury rate. Another reason why we are seeing rates increase too is the Fed is on a, they are taking liquidity out and they are raising rates as well. So we expect anywhere from two to three more rate raises this year, with more on the back of that next year as well. So we are now finally seeing a rising rate environment, which isn’t the best scenario for fixed income investors.
On the spread side, we have seen spreads compress and in IG they hit a low this year of 81 basis points above the Treasury. We now have started to see that wind back and kind of sell off. High yield hasn’t had the same reaction, so we actually look at high-yield spreads as being relatively tight where we are in the cycle. So with rising inflation, rising rates and the supply technical picture, the only positive is fundamentals remain very strong in the U.S. right now. But we don’t think that is enough to keep credit spreads where they are, or you are not getting paid enough to extend duration or invest in longer-dated securities for the spread you are receiving right now, whether that is an investment grade or high yield.
Managing the fixed income side now is selling down longer-duration, so 10-year corporate bonds, 30-year corporate bonds, and moving into shorter-duration securities, call it 1- to 3-year duration, where they are going to mature in the next couple of years and get paid off. That does a couple of things: One, it locks in the yield that you are going to receive as a fixed income investor.
A good example of going shorter-duration in the high-yield market and still picking up some decent yield is if you look at a Teva, they recently got downgraded to high-yield market. The management team is doing everything they can to get back to investment grade to pre-high-quality global pharmaceutical company. They have cash on the balance sheet and revolver capacity to take those bonds out. So another example is there is a cable company, Cablevision, that has very high coupon bonds, where the management team has said they are going to refinance those bonds.
We think in a rising rate environment where spreads are widening, it is going to be harder to get a positive total return in fixed income.
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