The Return of Inflation: A Relative Value Opportunity for Fixed Income Investors
May 15, 2018 By Sage Advisory
Interest rates have increased dramatically since the end of 2017 and are expected to continue climbing. How can fixed income investors insulate themselves from inherent risks while taking advantage of the opportunities presented by this change in market dynamics? At Sage, we believe the best course of action is to make a strategic shift from fixed to floating rate bonds, which offer benefits that may not be so obvious to investors.
Market dynamics: Why rates will continue to rise
U.S. Treasury rates have increased for both fundamental and technical reasons, including commodity price increases, labor market tightening, and the Fed’s shrinking balance sheet.
Inflation expectations have in shot up in recent months due to an increase in commodity prices and tightening labor market conditions. With unemployment in the U.S. now below 4%, labor has become scarce, and thus wages should increase. The chart below shows the breakeven rates on Treasury inflation-protected securities (TIPS), used as a proxy for inflation expectations, which are on the rise.
Various geopolitical factors, including conflict with Iran, poor oil production performance from the leftist government in Venezuela, and increased global demand for liquefied petroleum products has caused the price of oil to increase dramatically in 2018.
In addition to these fundamental shifts, there is a large technical factor driving Treasury rates higher. The U.S. Federal Reserve’s Federal Open Market Committee (FOMC) has begun to shrink its balance sheet, allowing up to $10 billion of Treasuries and mortgages to “roll off” each month rather than reinvesting in those markets. The FOMC has been one of the largest buyers of U.S. Treasuries and mortgages, but is paring down assets to $2.5 trillion from $4.5 trillion at the peak. We anticipate that net global quantitative easing, used to support fixed income markets, will become negative by October, as the European Central Bank and the Bank of Japan also decrease their balance sheets.
What should fixed income investors do in a rising rate environment?
It may seem obvious that one would want to invest in floating rate bonds as interest rates increase, because rising rates will cause the coupons of floaters to rise in tandem with nominal rates, while fixed rate coupons will remain the same, causing the price of these bonds to decrease. But there is an additional benefit that may not be so obvious to most investors.
Floating rate asset-back securities (ABS), corporate bonds, and leveraged loans are all priced based on LIBOR, the London Interbank Offered Rate. This rate is set by a consortium of banks in the UK, and it is meant to represent the rate at which one bank would lend to another at various maturities. The ABS floaters generally price off the one-month LIBOR rate, while corporate securities generally use the three-month LIBOR rate as the benchmark. Because it is a rate of interest between banks, LIBOR has a credit component embedded along with pure interest rate considerations. As such, LIBOR rates tend to increase during periods of financial stress, while pure nominal interest rates tend to decline.
The chart below shows LIBOR versus the two-year U.S. Treasury. During the Dotcom Bubble, the Great Recession of 2008 and, to a lesser extent, during the European Debt Crisis of 2011, LIBOR increased while nominal rates decreased (as is typical in a “risk-off” environment).
This increase in LIBOR allows the coupon to increase to levels that will insulate bondholders somewhat from the dramatic spikes in both interest rates and credit spreads. The fixed income market has benefited from a prolonged low-spread and low-rate environment, but there’s reason to believe that may be coming to an end. As credit spreads increase concurrently with rising interest rates, we believe that floating rate bonds and loans are the best place for fixed income investors to achieve positive returns.
*Source on all charts is Bloomberg.
Disclosures: This is for informational purposes only and is not intended as investment advice or an offer or solicitation with respect to the purchase or sale of any security, strategy or investment product. Although the statements of fact, information, charts, analysis and data in this report have been obtained from, and are based upon, sources Sage believes to be reliable, we do not guarantee their accuracy, and the underlying information, data, figures and publicly available information has not been verified or audited for accuracy or completeness by Sage. Additionally, we do not represent that the information, data, analysis and charts are accurate or complete, and as such should not be relied upon as such. All results included in this report constitute Sage’s opinions as of the date of this report and are subject to change without notice due to various factors, such as market conditions. Investors should make their own decisions on investment strategies based on their specific investment objectives and financial circumstances. All investments contain risk and may lose value. Past performance is not a guarantee of future results.
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