At rates of 1% to 2%, the Fed risks being forced to bring "a knife to a gun fight" in future crises, McDonnell says.

The question at a recent press briefing with Delaware Investments wasn’t “will the Fed raise rates this year, or won’t they?” nor was it “will it happen in June or September?” but “will it be enough?”

Even if the Fedreal Reserve raises interest rates, will that be enough to fight any future economic weakness?

Three bond managers from Delaware Investments recently spoke at a press briefing in New York City about the fixed income market and the expectations for the Federal Reserve to begin raising rates.

“I don’t think the Fed necessarily wants to raise rates. I just think they want higher rates,” said Brian McDonnell, a senior vice president and senior portfolio manager at Delaware Investments.

“And, I think if they raise rates gradually, if they get to say 1% or 2%,” he added, “I think the thought is that if they get to a higher rate, they’ll actually have some ammunition if we go into another recession or start to see some economic weakness.”

McDonnell, a member of the firm’s taxable fixed income portfolio management team with responsibility for portfolio construction and strategic asset allocation, is not so sure.

“I don’t actually buy that argument that if they get up to 1%, they’re going to have enough ammunition to stave off any sort of economic weakness,” he said.

McDonnell pointed to past easing cycles where “most of them have averaged between 300 and 500 basis points.”

“So, if they get to a 1 or even a 2% funds rate that doesn’t necessarily give them a whole lot of ammunition if they do see some economic weakness,” he said. “It’s kind of like bringing a knife to a gun fight.”

McDonnell’s colleague Greg Gizzi called the rate rise the obvious “elephant in the room.”

“[T]he level of transparency that really is in the markets today particularly the level of communication we get from the Federal Reserve, I don’t think the rate rise is going to take anyone by surprise,” said Gizzi, a senior vice president and senior portfolio manager at Delaware Investments. Gizzi is a member of the firm’s municipal fixed income portfolio management team.

The question for Gizzi is less about when the rate rise will happen and more about what happens after the rates start rising.

“We’re going to have to really look at the data when they start to embark on rising rates to really learn the trajectory of rates,” he said. “Are we going to see a gradual rate rise of the curve shift ladder, where income is going to drive the day? Or are we going to see a severe spike in rates and the long end of the curve steepen out?” Because the municipal bond world is still a retail product with more than 70% of the market in individual hands purchasing either directly or through mutual funds, Gizzi doesn’t want anything that’s going to spike interest rates or potentially cause fear in the mind of investors in the muni market.

Take the year 2013, for example.

“2013 turned out to be a very poor year for municipal bonds,” Gizzi said. “Spring of 2013 we saw the taper tantrum ensue, followed by credit events in our market: the degradation of Puerto Rico, the filing of bankruptcy by Detroit, which caused a run on funds.” 

This is why Gizzi stresses this point, “As an investor, it’s incumbent on you to make sure you’re selecting the right securities more so than it is to be adept at predicting interest rates.”

Instead of predicting interest rates, Gizzi predicts that despite the eventual rate rise that “we believe will happen at some point in 2015,” municipal investors would still be able to have a “low- to mid-single digit return.”

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