It’s true; the Federal Reserve (Fed) will likely move to raise interest rates this year, but that is not necessarily going to be the only story of 2015. The fixed income market may become segmented, and we expect the yield curve will continue to change shape. As a result, investors are likely to have very different experiences depending on the themes they are focused on.
We believe that pension funds and insurance companies should continue to be major sources of demand for longer dated credit risk, as will foreign investors who are taking much more interest in US fixed income given the yield starvation elsewhere. The municipal market should continue to offer value for tax-paying investors in the US. High yield and emerging market debt markets have proven in 2014 that the additional yield they offer comes with additional risk.
Market segmentation
We have recently spent a lot of time looking at the impact that interest rate rises have had on different parts of the market during previous rate rising cycles. Each cycle is different. The timing and magnitude of the rate moves differs, as does the starting point. Today’s market is certainly different than the last time the Fed embarked on raising rates.
The one definitive conclusion from looking at previous episodes is that the impact on market segments will not be uniform. Many commentators love to talk about the changing language coming from the voting members of the Fed, but forget to mention that an increase in the Federal Funds rate does not translate to a parallel shift across the yield curve. In fact, a flattening of the yield curve is probably a lot more likely, given the current steepness that exists.
As we know from experience in the UK, it is entirely plausible for different market segments to become dislocated from one another, and even move in opposite directions. Many investors have reduced their exposure to interest rate moves – or ‘duration’. More accurately, many have shifted duration exposure to short-dated bonds, in both credit and municipals. This is the very part of the market likely to be most directly impacted by short-term interest rate increases.
We published a paper last year titled ‘The Great Re-Rotation’, which focused on the demand from US private sector pension plans for longer-dated investment grade corporates. A year later, we have been surprised that this did not have a more material impact on the market, but we do not think that demand has gone away. Long dated credit is cheaper now than this time last year, and should benefit from this natural buyer base.
Pension plans continue down the path towards more liability-conscious investing. Although we did not get our timing right this year, we think this dynamic remains in place. This involves a change in mind-set to one of relative returns and away from an absolute return focus.
Value in credit?
Since the financial crisis, corporate credit risk had been the gift that keeps on giving. However, as of early December, excess returns in the US have turned negative. Credit curves have steepened through the year and confidence has been adversely impacted by the volatility we have seen in the second half of 2014.
However, the fundamental backdrop remains broadly supportive for credit investors. Naturally, we need to remain vigilant - we must remain wary of shareholder-friendly actions and a lack of discipline from corporations - but we anticipate some interesting opportunities in corporate credit. Investors with a longer term investment timeframe should do better than short-term players. Recent price moves are more about sentiment and liquidity concerns than a change in the ability of the average investment grade corporate to pay back the principal and the coupon on their debt obligations.
High yield and emerging markets have been a challenge for investors over the last couple of months. If there is one positive that has emerged from the recent moves it is that it should begin to provide a more stable technical backdrop. In both markets, security selection remains key.
It is no longer appropriate to make broad statements about emerging markets as an asset class, as some sovereigns are solid investment grade names. Similarly in high yield, there is a difference between the struggling energy issuers and more stable sectors which are well positioned for the coming months.
Demand from foreign investors
Demand and supply distortions can often have a material impact on markets but are frequently discounted in favor of discussions on more dynamic topics such as growth, inflation and rate expectations.
We believe that further demand for US credit from overseas investors is not fully appreciated by market participants. Clients in Europe and Asia are showing a renewed level of interest in US corporate bonds. Starved of yield in their home markets, international investors are taking a much closer look at the US. With over 50% of government bonds around the world yielding less than 1%, a 7-10yr US corporate bond portfolio yielding above 3.5% certainly gets some attention.
In 2015, the Fed’s decisions will undoubtedly be important, but investors should not be blinded by what happens at the short-end of the yield curve. We expect volatility to continue, opportunities to emerge and the potential for different parts of the market to move independently. Liquidity is deteriorating, but that is just another inefficiency on which we will look to capitalize.
Andy Chorlton is Head of U.S. Multi-Sector Fixed Income at Schroders Investment Management and Portfolio Manager for the Broad Tax Aware Value Bond (STWTX) and Long Duration Investment Grade Bond (STWLC)
