It has been abnormally calm in the fixed income markets for way too long. Ever since the great recession, fixed income markets have been driven by the twin calming forces of a very accommodating Federal Reserve and a slow economic expansion. As these forces change, market volatility is changing as well. In the first quarter we saw a return of volatility and an increase in interest rates, which pushed returns slightly negative. The good news for us is that volatility in our markets pales in comparison to what other markets (i.e. stocks) experienced, which is exactly what we’d expect from high quality fixed income.
1Q18 Index Returns ICE/BAML Intermediate Index Returns (1-10 Yr)
Interest Rates: The Fed is now steadily raising rates from rock bottom levels because the economy is performing well. This is good news. Unemployment at 4.1% is below the Fed’s target for full employment, GDP is in long-term recovery and projected by the Fed to be 2.7% in 2018, and inflation may even reach the Fed’s target of 2.0% by the end of 2019. The Fed’s generous accommodation over the last decade seems to have worked!
The fed funds rate was essentially below 1.0% from 4Q08 to 4Q16; the rate was abnormally low for an extended period of time and was implemented to help the economy repair and recover. While this repair was good for the overall economy, it was not good for investors with money in the bank or fixed income investors looking for income. But times are getting better as the fed funds rate target is now 1.5% -1.75% and projected to go higher. If the Fed’s expectations come to fruition, the fed funds rate could be around 3.0% by the end of 2020. This would be a far more normal level by historical standards. This normalization of rates will offer more income to investors over time, but when the Fed raises rates it always seems to add to volatility. Nothing is free.
Corporates: Corporate credit spreads widened in Q1, which means investors are now demanding more yield compensation to lend money to corporations. This widening was off post-financial crisis tights and largely due to technical factors that are likely to stabilize. We believe it will be hard for spreads to become really volatile until there is some threat to corporate fundamentals or until investors fear the coming of the next recession. Corporate profits are anticipated to be very strong throughout 2018 and there is no indication the economy is close to a recession. However, if investors foresee a weakening of the economy due to an exogenous effect like an escalating trade war, the spread picture could change.
Municipals: One market that has largely side-stepped volatility this year has been munis. Municipals are back to their sleepy ways after a tax-reform induced bout of volatility at the end of 2017. The tax reform bill passed late last year is reducing the supply of municipals bonds as the new law eliminated the ability for municipalities to issue advance refunding bonds on a tax-exempt basis. Less supply with steady demand helped municipals outperform other sectors of the investment grade market. As the year goes on we expect this trend to continue.
Overall: Increased volatility pushed most fixed income markets negative this quarter, but it is good to remember volatility is equal opportunity. That is, volatility can be both negative and positive and hard to predict. Consequently, we believe the safest way to bet at this time is that volatility will increase.
So how do we position portfolios when the highest confidence scenario is just more volatility? For a start, investing in high quality bonds is certainly a great way to control volatility compared to most other asset classes. And keeping duration close to the index helps to ensure returns do not stray too far from expectations. Finally, sector and security selection in portfolios can acknowledge that volatility is picking up. We make every asset class allocation and security choice with an eye to how it will return as volatility picks up, and we fine-tune portfolios as our views evolve.
While it is true volatility may be coming back after a long absence, getting back to a more normal level of interest rates and earning more income is certainly positive for portfolios over the long-term.
Sources: Bloomberg, The Financial Times, The Wall Street Journal