February 12, 2015

The short answer to the question is “yes.” Despite global financial turbulence and central bank policies, fixed income will continue to provide steady income streams and serve as a source of stability and balance to mitigate the higher volatility associated with equity-only portfolios.

The short answer, of course, must take into account the grand monetary experiment following the financial crisis of 2008-09, which has included three rounds of quantitative easing (QE) in the U.S. and left in its wake the lowest interest rates in fifty years. As of February 6, 2015, the 10-year U.S. Treasury is yielding 1.93%. The Fed has held its benchmark short-term rate near zero since December 2008 and is now poised to raise rates. While the Fed is expected to make its first move in the latter part of this year, we anticipate the increase to be nominal. Additionally,  we expect subsequent increases to be approached gradually at a measured pace, contributing to an extended low interest rate environment for longer than most would expect.

Interest rates are likely to remain low for a variety of reasons, from weak global growth and a divergence in global interest rates to government deficits and demographics.

When considering the global environment, we note that growth in China has slowed and Japan sank into recession late last year. Eurozone economies have also stalled, prompting the European Central Bank to embark on a large scale QE experiment of its own. Currently, non-U.S. credit rates are lower than U.S. Treasuries of comparable maturities. A sampling  of 10-year yields shows bonds in Switzerland at -0.15%, Japan at 0.35%, Germany at 0.36%, and France at 0.58% as of this writing. At these levels, which diverge widely from the 10-year U.S. Treasury at 1.93%, foreign investors  will flock to U.S. Treasury bonds for their relatively higher credit quality and more attractive yields. The result of this increase in demand will be to push prices up and yields down, as price and yield move in opposite directions.

“... foreign investors will flock to U.S. Treasury bonds for their relatively higher credit quality and more attractive yields.”

The U.S. deficit also indirectly exerts downward pressure on interest rates in the following way. Currently, the U.S. has a $486 billion budget deficit. Of the U.S. total budget of $3.7 trillion, $430 billion, or 12%, represents interest on debt. Clearly, it is not in the U.S. government’s best interest to raise interest rates rapidly, as the deficit’s interest component could rise exponentially and require servicing higher debt on the deficit. This motivation for the government to keep interest rates low contributes to the phenomenon known as “financial repression.”

Additional negative pressure on interest rates can be attributed to demographics. One in five Americans is projected to be over the age of 65 by 2030. Increasing numbers of aging baby boomers—with diminishing investment time horizons—are retiring and shifting asset allocations from historically riskier equities to fixed income, contributing to higher demand for fixed income securities. This increased demand for fixed income will push up bond prices and put additional downward pressure on already low yields.

As it prepares to hike interest rates, one of the indicators the Fed is watching is inflation. There had been speculation that the large volume of liquidity afforded by three rounds of QE would be difficult to unwind without sparking inflation. However, inflation has been hovering around 1.5% (below the Fed’s target of 2%) and will most likely remain at low levels due, in part, to the counter-balancing effects of a strong U.S. dollar. A strong U.S. dollar makes U.S. exports more expensive relative to similar goods in foreign countries, forcing U.S. companies to lower prices to compete. This may negatively impact margins, earnings and profitability for U.S. companies, resulting in weaker U.S. economic growth.

“As it prepares to hike interest rates, one of the indicators the Fed is watching       is inflation.”

Recent reports show that U.S. factory activity fell to the lowest level in a year last month as slower global growth has hurt demand for American-made goods. Additionally, the strong U.S. dollar will result in imported goods being relatively cheaper than similar domestic goods, contributing to tamer inflation.

Due to projected weaker U.S. economic growth, wage inflation is also unlikely to contribute to inflation. There is still sufficient slack in the labor force as companies such as American Express, eBay, Halliburton, and Schlumberger have announced layoffs in recent weeks. While the unemployment rate has improved, the economy has not exhibited sufficient strength to indicate that wage inflation has materialized.

“Fixed income historically generates lower returns than equity, but it does so with less volatile price movements. This stability helps preserve capital.”

Another factor influencing inflation is the recent dramatic oil price decline (please refer to Max’s article in this newsletter). Lower energy costs and cheaper imports will likely keep core inflation low. In fact, a weak global growth environment now makes deflation more of a worry than inflation. If prices are expected to decline and consumers have an incentive to delay purchases and consumption until prices fall further, overall economic activity can be reduced, hampering growth. As this reduces productive capacity, investment also falls, leading to further reductions in overall demand and to a deflationary spiral. This could potentially exacerbate already weak global economic conditions. While central banks know how to deal with inflation, they have limited tools on dealing with deflation.

Even with all these pressures keeping interest rate levels low, fixed income will continue to play the important roles of providing stability and income to a portfolio. A company can reduce or eliminate a stock dividend, but is obligated to pay the interest promised in a bond covenant. For this reason, fixed income provides a more dependable income stream. Fixed income historically generates lower returns than equity, but it does so with less volatile price movements. This stability helps preserve capital. While one may be inclined to focus on price movements when interest rates begin to increase, it is important to retain a total return perspective; both current income generated and price appreciation/depreciation should be considered rather than focusing on price appreciation or depreciation alone.

When choosing fixed income investments, credit quality and the risk-reward relationship are important considerations as well. For example, credit spreads of bonds in the energy sector have recently widened due to the negative impacts caused by the oil price decline (approximately 18% of the high yield bond market is comprised of oil and gas company issues). While it may be tempting to chase after the typically greater yields that low-credit quality bonds generate, one must determine whether adequate compensation is received for undertaking higher credit default risk.

In the context of a low interest rate environment, fixed income investments are essential to providing stable income with minimum volatility. We at Clifford Swan recognize that selectivity is paramount as we consider all factors when making fixed income investment decisions for our clients.

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