• The Fed may have new urgency to raise rates because global growth has fundamentally strengthened
  • If history is any guide, bond yields could be rising for a sustained period
  • Sectors outside of common benchmark indexes might offer the most attractive potential in the emerging environment

Although a new economic policy has yet to emerge in Washington, the stock market and bond yields have nonetheless moved higher since President Trump’s election victory last November. Market commentators have characterized the “Trump bump” as a leading driver of recent market performance, as investors anticipate deregulation and tax cuts from the Republican-led government will stimulate faster economic growth.

However, factors of equal or possibly greater importance to the market’s success have been better U.S. and global economic growth, higher inflation expectations, steeper yield curves, and better earnings expectations, which had already begun to improve last summer, months before Trump’s election.

The Fed has reasons for urgency

As the U.S. economy expands, the Federal Reserve is charged with keeping inflation under control, and it may have already have fallen behind in this task.

Historically, the Federal Open Market Committee (FOMC) has had a dual mandate — maximum employment and moderate inflation. However, to protect the economy from a deeper recession, the Fed kept the federal funds rate at record lows from the 2008 financial crisis to 2015. Today, however, the FOMC is in catch-up mode and needs to ”normalize” interest rates by bringing the fed funds rate higher. Consensus estimates are calling for at least three Fed rate hikes in 2017.

What will an accelerated pace of Fed hikes mean for investors after almost a decade in a zero-interest-rate environment? In short, it may be time to rebalance fixed-income portfolios as the risk environment shifts.

Bond market cycles tend to be long term

Interest rates — and bond yields, especially — follow very long-term cycles. In the last long-term rising-rate cycle, from 1945 to 1982, 10-year Treasury yields climbed from a low of 2% to a high of 16%. Since peaking in the early 1980s, yields have been on a steady decline for 35 years.

Treasury yield cycles can last decades

Investments made at low yields may face losses

The low-rate environment of the past several years has quietly exposed investors to unprecedented interest-rate risk. Relatively small increases in rates would eradicate the yield that bonds provide today and cause losses for bond investors.

To what extent are investors presently exposed to interest-rate risk? Over the past 29 years, more than 30% of the net inflows into fixed-income mutual funds and ETFs have occurred when government bond yields were below 2%. A rise in long yields of just 100 basis points would translate into $1.6 trillion in unrealized losses for domestic bondholders.

Interest-rate risk is greater for longer-term bonds

Since 1959, 10-year yields have averaged 6.2% — just under nominal GDP growth rates of 6.6%. If President Trump’s policy goals are enacted, and federal spending increases while taxes are cut on individuals and businesses, better nominal growth is a distinct probability. If nominal GDP growth and Treasury yields continue to climb, we could expect to see an exodus from fixed-income markets and a subsequent drop in bond prices. Diversifying into non-traditional fixed-income products, therefore, is essential to help mitigate potential interest-rate risk.

Income investors should look outside of indexes

De-emphasizing interest-rate risk necessitates exploring less traditional fixed-income sectors. Examples include high-yield bonds and mortgage-backed securities. High-yield bonds earn higher coupon income as compensation for their greater default risk, but the higher coupons provide a buffer against interest-rate risk compared with higher quality bonds of similar maturities. Also, a stronger economy tends to reduce default risk. As for mortgage-backed securities, they also can benefit from a positive GDP trajectory and healthy real estate fundamentals, which tend to improve with the economy.

In addition, interest-only (IO) securities tend to do well when interest rates are rising. IOs represent the interest portion of mortgage payments, and when rising rates subdue mortgage refinancings, the streams of interest payments remain more consistent. IOs can also provide a diversifying position versus credit risk exposures.

Higher rates make it time to reexamine fixed-income strategies

As we leave the zero-interest-rate era behind and enter into what could be a multi-decade period of higher yields, it is essential that fixed-income investors reevaluate the risk exposures of their portfolios. Relatively small interest-rate increases could cause bond price declines that are greater than the yields that investors are currently earning on bonds purchased in recent years, when rates hovered near historic lows. A prudent income strategy today should look outside interest-rate-sensitive benchmarks for fixed-income strategies that are more prepared for the evolving risks emanating from a steady stream of rate hikes.