After years of near-zero returns, bond investors are benefitting from increasing short-term rates.

Jul 2018

After years of near-zero returns, bond investors are benefitting from increasing short-term rates. The Federal Funds rate in the U.S. is now 2%, and we expect it to rise to 2.5% by the end of this year. We are seeing this translate into higher returns on cash held in client portfolios, which is now about 1.7% after hovering near zero for many years. Yet even as short-term rates rise, longer term Treasury rates have risen only modestly. This has resulted in a “flatter” yield curve, meaning the additional yield compensation for owning longer bonds has fallen. The biggest question investors are asking is – will the yield curve invert? In other words, will long-term rates fall below short-term rates? This is significant because an inverted yield curve has often foreshadowed an impending recession within 24 months. It has correctly signaled every recession since the 1950s.

Our view is that the Fed under Chair Powell has a preference to see short-term rates at or above 3%. With full employment and gradually increasing inflation, there is ample evidence to justify it. But most importantly, doing so would give the Fed “wiggle room” to start lowering rates when further stimulus is required. Under this assumption, the Treasury curve is likely to look very flat at close to 3% regardless of the maturity. Whether long rates move below short rates is somewhat of a technical factor, and will depend on inflation, demand for U.S. Dollar assets relative to other currencies, and investor risk appetite. Generally speaking, we expect the yield curve to continue to flatten, though we don’t expect an imminent inversion and subsequent recession.

The other factor we are watching closely is corporate leverage. While borrowing costs have fallen sharply, corporations have been able to dramatically reduce the cost of debt as they have largely refinanced bonds and borrowed with longer terms and lower interest costs. Yet leverage has risen for investment grade borrowers, while the extra yield spread on lower rated debt has fallen. Though very low, default rates for below investment grade (high yield or “junk”) bonds have crept up to about 2.3%.

In the municipal market, we are seeing a rotation of some larger insurance investors away from the muni market as they adjust to changes in the tax rate, and also take gains on longer-term holdings. This has created some opportunities, which we are taking advantage of where appropriate.

Our approach to investing in this environment remains, as always, with a focus on capital preservation, safety, and return of principal.

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