Yielding to Rising Interest Rates

Direction of interest rates is shifting higher in 2017. In mid-March, the US Federal Reserve raised short-term rates by a quarter percentage point and said two additional lifts are very likely this year. Also, with inflation picking up across the globe, including 2% inflation now for the euro area, a climb in rates is expected in several economies. What does it all mean for income-seeking investors?

A multi-asset income, a European fixed income, and a US municipal bond manager, along with our Chief Market Strategist, share their insight on a transitioning landscape, places to look for income in a rising-rate environment, and fortifying portfolios.

Our Panel Responses

Maura Murphy
Maura Murphy, CFA®

Vice President and Portfolio Manager Loomis, Sayles & Company

After getting used to searching for income in a state of steady yields, change is upon us. The investment landscape in which we now must navigate is transitioning to one of rising interest rates, as well as growth and inflation.

The US Fed has broadcast its intention to raise interest rates three times in 2017. After March’s rate hike, barring any downdrafts in growth or inflation, we should expect two more Fed increases this year. At the same time, we are taking into account diverging monetary policy globally. In terms of the European Central Bank (ECB), we think that they're going to maintain quantitative easing (QE) at $60 billion for all of 2017. However, we do expect they will start talking about tapering. This could introduce a scenario where yields start backing up pretty quickly in Europe.

In Asia, the Bank of Japan seems to be looking to anchor yields at zero for much of 2017 – hoping that they can keep their currency weak. The central bank in China, the People’s Bank of China, appears to be tightening liquidity and trying to stem capital flight. So we've got some diverging policy going on, and it will be critical to see how that dominates market action throughout the year.

US in late-cycle expansion
As we analyze credit cycles across the world, we believe the US is in late-cycle expansion. However, the possibility of a fiscal stimulus that has been put on the table by the Trump presidency could extend the cycle slightly longer than we thought. So recession is not something that we're assessing as a big risk for 2017, or probably for much of 2018. We believe Europe is in recovery phase and Japan is moving out of credit repair into the recovery phase. Brazil and Colombia specifically, we think, have entered the credit repair phase of the cycle. Other emerging market countries such as Turkey are still in a downturn. Economies worldwide are at varying parts of the cycle.

Opportunity among dividend-paying global equities
One place that we're interested in for much of this year is global equities, and specifically in Japan. We think that Japanese equities could be an interesting source of income this year. They're benefiting from the weaker Japanese yen and corporate reform, and we think that many Japanese companies are increasingly becoming more shareholder-friendly.

Financials more attractive
We are currently positive on European and American financials, but would avoid emerging market banks and Asian banks, specifically Turkey, Mexico, Korea, and most of Asia. Back in the US, if the Trump administration does push through some deregulation, and if it were to reform the Dodd-Frank Act (legislation passed in 2010 to govern the financial industry) and repeal some labor regulations, that could all be beneficial to banks. Additionally, if we see increased manufacturing in the US, combined with regulatory reform, it could be pretty bullish for loan demand, which would help some of the regional banks as well.

Bank loans, Brazil, and energy
When we think about higher interest rates and higher inflation, it’s important to select fixed income sources that are less rate-sensitive. Therefore, we believe the bank loan sector is more favorable. Also on the debt side, we are finding interesting yield opportunities in Brazil and Argentina in 2017. Both economies have gone through very deep recessions but now have new economic policies and appear to be starting to stabilize. We have seen some attractive yields in the low double digits. Another area where we are finding interesting sources of income is in energy-related MLPs (master limited partnerships) and energy-related high yield bonds and dividends.

Overall, we believe having the flexibility to adapt to changing credit cycles and market environments will become more critical as we move through 2017. Also, volatility has been extremely low for several months now. However, it could reappear at any moment, especially given where we are in the economic cycle.
Maura Murphy, CFA®, is a Vice President and Portfolio Manager at Loomis, Sayles & Company.

Maura Murphy is a vice president and portfolio manager at Loomis, Sayles & Company. Ms. Murphy began her investment industry career in 2003 upon joining Loomis Sayles as a quantitative analyst. In 2007, Ms. Murphy moved to a position as absolute return analyst, working as an investment strategist for all absolute return oriented portfolios.

Ms. Murphy earned a BA in mathematics from the College of the Holy Cross and an MBA from the Carroll School of Management at Boston College. She is a CFA® charterholder.

CFA® and Chartered Financial Analyst® are registered trademarks owned by the CFA Institute.

David Lafferty
David Lafferty, CFA®

Senior Vice President and Chief Market Strategist Natixis Investment Managers — US Distribution

The ground is clearly shifting beneath the feet of bond investors. For much of last year, there was a clear bifurcation within the fixed income markets. High-quality sovereign bonds were trading at historically low yields as the European Central Bank (ECB) and the Bank of Japan (BOJ) continued to push their negative-rate policies at the short end of the yield curve. Longer rates also fell as the global economy seemed to teeter with fears of a China-induced global slowdown. At that time, sovereign indexes with paltry yields and long durations hardly seemed like a bargain. Meanwhile, corporate bonds all of stripes, including investment grade, high yield, and convertible, as well as bank loans offered significantly better yields with much less rate risk.

Fast-forward to today and while credit sectors still look somewhat attractive relative to sovereign and agency paper, rising yields and falling credit spreads have narrowed this gap significantly. We don’t see the credit cycle ending just yet, but bond investors who may now be overexposed to the credit sectors may want a better balance between interest-rate risk and credit risk.

Inflationary pressure building globally
As for the direction of interest rates, much of the near-term pain has already been felt – Q4 of 2016 was one of the worst quarters in history for high-quality bonds as rates jumped on the prospect of pro-growth Trumponomics. Globally, supply-side limitations on labor force growth and productivity could restrain the economic expansion. Real interest rates, as a proxy for real growth, should rise, but only modestly. The greater risk to bonds is an outbreak of inflationary pressures. With US unemployment already below 5% with 5.6 million unfilled jobs, significant fiscal expansion by the Trump administration is likely to be inflationary.

The risk of higher inflation is not solely a US concern. Inflationary pressure is also starting to percolate in Europe while in the UK inflation is being stimulated by a weaker pound sterling since the Brexit vote. Both real growth and inflation are likely to push nominal interest rates gradually higher, but the uncertainty around inflation is a much greater threat.

Three things for income investors to consider
Within this landscape, there are some steps income investors can take to create a more durable allocation.

  1. Seek a better balance between interest-rate risk and credit risk. The credit cycle should remain benign in the near term, but valuations aren’t compelling enough to warrant an overexposure to credit. High-quality bonds, often referred to as the “ballast” in a portfolio, have become less unattractive in recent months as starting yields are now a bit higher.
  2. Keep a close eye on inflation, as it is a more likely culprit for portfolio pain if rates do rise. With the 10-year inflation breakeven near 2% in the US, inflation-protected securities can mitigate some risk if broad price levels jump unexpectedly.
  3. Look for bond-like characteristics outside of the bond market. Hedged or low-volatility equity strategies may be able to keep portfolio risk in check without exposing investors to either rising rates or inflationary pressures.
David Lafferty, CFA®, is a Senior Vice President and Chief Market Strategist at Natixis Investment Managers — US Distribution.

David Lafferty is Senior Vice President and Chief Market Strategist at Natixis Investment Managers. He is responsible for assessing economic and capital market trends and their implications for investment portfolios. His team also works with affiliated asset managers to develop portfolio insights. He has been with Natixis since 2004. Previously, Mr. Lafferty was senior vice president responsible for fixed-income and asset allocation products at State Street Research & Management, developing investment strategies for institutional clients with assets ranging from $10 million to $2 billion. From 1998 to 2001, he was a senior investment strategist at MetLife, structuring asset allocation programs for institutional clients with assets totaling $600 million. From 2008 to 2012, he served on the Board of Directors of Caspian Capital Management/Caspian Private Equity, a New York based hedge fund and private equity firm.

Mr. Lafferty is a frequent speaker at industry events and is often quoted in Barron’s, Bloomberg, The Wall Street Journal and other financial publications. He received his BA from the University of New Hampshire and his MSF (Master of Science in Finance) from Suffolk University. He is a member of the Boston Security Analyst Society, the CFA Institute, and the National Association for Business Economics (NABE) and has more than 20 years of investment industry experience.

Olivier de Larouzière
Olivier de Larouzière

Head of Interest Rates, Senior Portfolio Manager Natixis Asset Management in Paris

The recent uptrend in rates, after having reached new lows in 2016, is evenly composed of growth and inflation expectations in the US and only inflation in the euro zone. Considering that the current growth cycle will most likely weaken at the end of 2017 or 2018, this supportive factor may fade away.

The impact of the Fed’s monetary policy tightening should remain concentrated on short and medium-term rates. Only a surprise (sudden rise in oil prices?) would have an impact on longer maturities. In the euro area, even if the European Central Bank (ECB) starts tapering at the end of 2017, the Public Sector Purchase Programme (PSPP) remains huge versus the issuance needs of Euro sovereigns. The maturities of these operations are starting to reduce in Germany and will further steepen the yield curve by bringing short-term rates even lower than today. This steepness of the yield curve does limit a sharp rise of long-term rates. Hence, long-term rates should gradually rise in the US and Germany in the coming months, but not far from the equilibrium levels which we estimate at 2.6% and 0.5%, respectively.

Growing importance of maturity selection
In this current environment of low/negative yields and steep yield curves, investors may want to focus on maturity selection. Carry and roll-down have a mechanical and very positive effect when yields have no trend. Investors may maximize this effect by choosing the right maturities. This choice has to be done country by country and include, tactically, an analysis of the issuance programs from these countries as they could distort the curves. Managing duration tactically is also important because volatility hasn’t actually diminished even if yields are low.

Country and maturity allocations have to be active, as mentioned previously. In Germany, we tend to favor medium-term maturities which should benefit from the PSPP. Spanish bonds appear more favorable compared to French and Italian bonds, particularly on medium-term maturities. If the news flow becomes more positive for these two countries, investors could begin to flow back to these very large and liquid debt markets. Long maturities (10-year and longer) for French and Italian bonds should then offer a more attractive carry.

ABS, senior-secured loans, high yield bonds
Credit investments offer opportunities in the financial sector or in high yield bonds if investors are looking for a premium versus sovereigns. As far as credit is concerned, because of expected higher rate volatility, one may favor asset-backed securities (ABS) and senior-secured loans. Because ABS and senior-secured loans are floating-rate products, as such they’re not very sensitive to a likely rise of interest rates. High yield (HY) bonds deserve some attention as HY spreads also tend to be negatively correlated to interest rates, which means that sub-investment-grade bonds should fare quite well this year. Last but not least, focusing on short-duration investments is another way of performing almost always positively whatever the state of nature.

Editor’s note: Philippe Berthelot, Head of Credit, Portfolio Manager, at Natixis Asset Management, contributed to this commentary.
Olivier de Larouzière, is a Head of Interest Rates, Senior Portfolio Manager at Natixis Asset Management in Paris.

Olivier de Larouzière is Head of Interest Rates and a Senior Portfolio Manager at Natixis Asset Management in Paris. Olivier joined Natixis Asset Management (NAM) in 2003 and has held several leadership positions. Prior to his current role, he was Head of the Euro Fixed-Income team. Before coming to NAM, he was a senior fixed-income portfolio manager at Credit Lyonnais Asset Management, a fixed-income proprietary trader at BNP Paribas and a fund manager at Ecureuil Gestion. Mr. de Larouzière has more than 20 years of investment industry experience and holds a diploma of advanced studies in mathematics applied to economic studies from the University of Paris IX – Dauphine.

James Grabovac
James Grabovac, CFA®

Managing Director and Investment Strategist McDonnell Investment Management, LLC

While the Fed’s rate hikes in 2017 are expected to be quite gradual, there are favorable dynamics of US municipal bonds in rising-rate environments to be considered. Tax-advantage and credit quality attributes, along with supply, have historically helped municipal bonds fare better than other types of bonds when rates rise.

For example, municipal bonds tend to exhibit less volatility than Treasuries in a rising rate environment due to new issue supply. When rates rise, municipal issuers are less likely to issue bonds to refinance older, higher rate debt and, as a consequence, new issue supply tends to fall. Conversely, when rates decline issuers have a strong incentive to issue Refunding Bonds. Higher rates can reduce this supply factor at the margin and in turn help dampen some of the downside potential in the municipal market during periods of generally rising interest rates.

Challenges and opportunities for US municipal market
That said, there are a few other challenges and opportunities to consider for the US municipal market today. As investors assess the capital market outlook over the near and medium term, the US municipal market faces potential legislative initiatives which could influence performance, as well as provide additional areas of opportunity for both traditional and non-dollar municipal investors. Consider the following two large policy initiatives being discussed in Washington:

  1. Tax policy changes – Directionally, both the Trump administration and Congress are in favor of reducing marginal tax rates. Since most of the muni market is federally tax-exempt, lowering tax rates reduces the benefit afforded by investing in tax-exempt municipals. While it is important for investors to be aware of the potential impact of tax changes, it is also important to note that relative valuations in the municipal market are reflective of a wide variety of factors that reach beyond marginal tax rates. Credit quality, liquidity, yield and correlation characteristics, among others, all play a critical role in the valuation and performance of individual securities as well as the market in aggregate.

    Municipal market valuations have tended to exhibit limited correlation to changes in top marginal tax rates. Historically large reductions, such as occurred in 1987 when top rates dropped from 50% to 38.5% and 1988 when rates were cut to 28%, had no discernible impact on municipal versus Treasury valuation ratios. In today’s environment, municipals have the benefit of a “valuation cushion” as investors move out across the yield curve.
  2. Infrastructure Investment – The Trump administration has expressed a desire for a large infrastructure investment program to stimulate economic growth and to help lay the foundation for future gains in productivity. They also favor utilizing the Public Private Partnership model (P3) as a means of introducing efficiencies and harnessing private capital. This model can be effective for certain types of infrastructure projects. It has been used selectively to fund toll road and airport expansion projects, among others, and projects which have a steady stream of user fees available to provide a return on capital. This infrastructure initiative, however, is less likely to be effective for undertaking lengthy, large-scale public works projects – such as power plants, smart grid technology, water infrastructure, and bridge maintenance and construction.
Overall, we think that progress on policy initiatives will take longer and likely be moderated as the process moves forward. Now that the administration’s first policy initiative, Repeal and Replacement of the Affordable Care Act, has come to an abrupt end, congress will now begin to debate tax policy changes. We expect the desire for deficit control will ultimately curb consideration of the most aggressive rate reduction plans. Infrastructure investment, which should be the easiest to accomplish legislatively, falls last on the agenda.

US municipals’ growing global appeal
We expect there to be strong interest in the municipal sector from both US and non-dollar investors if the Infrastructure Program follows a traditional path. Increased issuance for infrastructure investment, potentially involving taxable issuance, and a developing credit cycle, all point toward heightened investor interest in diversifying asset exposure. The US municipal market can expect to serve an increasingly broader array of investors as the reach for good quality, higher yielding, and longer-term assets evolves globally.
James Grabovac, CFA®, is a Managing Director and Investment Strategist at McDonnell Investment Management, LLC.

James Grabovac is Managing Director and Investment Strategist at McDonnell Investment Management, LLC. In this role, he is responsible for executing tax-exempt investment strategies for the firm’s client portfolios, focusing on institutional client portfolios and subadvised mutual funds. Mr. Grabovac has over 30 years of investment industry experience.

Prior to joining McDonnell, Mr. Grabovac was an independent futures trader. He also managed tax-exempt mutual funds at Invesco Funds Group in Denver, and managed a high-yield municipal bond fund for Stein Roe & Farnham in Chicago. Mr. Grabovac also worked extensively with Stein Roe & Farnham’s insurance company clients.

Mr. Grabovac has an MBA in finance from the University of Michigan and a BA in economics from Lawrence University. He holds the Chartered Financial Analyst® designation and is a member of the CFA Institute as well as the CFA Society of Chicago.  

CFA® and Chartered Financial Analyst® are registered trademarks owned by the CFA Institute.