Investors’ long-held worries about low yields and limited investment income have now given way to expectations of rising inflation and higher interest rates.
Interest rates, which had been rising since July, took off immediately after last week’s election, pushing the 10-year Treasury yield from 1.83% at Monday’s market close to 2.07% on Wednesday, after Donald Trump emerged the winner.
Monday morning the 10-year Treasury yield was trading at 2.25%, capping the biggest weekly jump in yields since the 2013 “taper tantrum,” when yields surged suddenly on news that the Federal Reserve was about to taper its QE bond purchases.
This time markets reacted to Trump’s pledges to boost infrastructure spending and cut taxes, which could boost growth as well as deficits—both seen as catalysts for higher inflation and inflation expectations. In addition, Trump’s campaign threats to impose double-digit tariffs against Chinese (45%) and Mexican imports (35%), if realized, would add to inflation expectations.
Karissa McDonough, chief fixed income strategist at People’s United Wealth Management, calls the post-election rise in yields a “paradigm shift.”
“We felt very strongly even before the election that inflation was rising, says Terry Simpson, multi-asset investment strategist for BlackRock’s Global Investment Strategy team. “And now we support that position even more.”
In addition, says Simpson, there is now an “implicit” coordination between Trump and Fed Chair Janet Yellen to shoot for higher inflation. Yellen and the Fed more generally have been targeting a 2% annual inflation rate but Simpson says the Fed may be willing to let inflation rate run “a little higher. We’re telling clients 2% is not the ceiling.”
There are several ways for investors to adjust their portfolios to take advantage of this outlook for rising inflation, which will provide higher yields and income, but simultaneously depress the prices of fixed-rate bonds that have lower-than-current yields.
“If we are correct that inflation is going to rise, TIPS are also an under-owned asset class, with $8 billion inflows year-to-date,” Simpson said.
Maybe so, but since the beginning of November, just days before the historic election of a president with no experience in government, the military or public service, investors poured a net $1.45 billion into the iShares TIPS (Treasury inflation-protected securities) Bond ETF (TIP), the largest TIPS ETF, according to Morningstar.
TIPS have been outperforming ordinary Treasury notes and bonds this year. Through Friday, the Barclays TIPS index gained 7.3% while the Barclays U.S. Treasury Index rose 2.3%, according to Bloomberg.
Investors can buy TIPS ETFs or TIPS mutual funds or even individual TIPS from the U.S. Treasury via its Treasury Direct service. Among the top-performing TIPS mutual funds this year, according to Morningstar, are the institutional shares of DFA LTIP Portfolio (DRXIX), up over 12%, the PIMCO Real Return Asset Fund (PRAIX) and the Columbia Inflation-Protected Securities Fund (CIPZX), both up well over 9%.
TIPS are available in 5-, 10- and 30-year maturities so investors should check a funds’ average maturity and duration of the funds they’re interested buying.
Kathy Jones, fixed income strategist at the Schwab Center for Financial Research, suggests that investors today choose shorter duration funds because of the expectation of rising rates (duration is a measure of a bond or portfolio’s sensitivity to a change in interest rates).
“Start from low duration now and sprinkle in higher duration as rates rise further,” Jones said. She suggests a duration in the three- to five-year area.
One important consideration for buying TIPS funds is the breakeven point, where, given a particular inflation rate, the yield of a nominal Treasury bond is equal to the yield of a TIP. If the inflation rate is higher than breakeven point, TIPS are a better buy, if below that, traditional Treasuries should outperform. The current breakeven on the 10-year TIPs is close to 1.95% — up from about 1.72%, a week ago., meaning that inflation has to be that much higher over the next 10 years for TIPS to make sense as an investment now. “TIPS are now more an asset class play rather than just a pure valuation play,” says David Lafferty, chief market strategist at Natixis.
Another way for mutual fund investors to capitalize on rising rates is to invest in funds that focus on financial stocks. Bank stocks benefit when rates are rising and the yield curve is steepening because they can charge higher for loans than they pay in interest to depositors.
In addition, bank stocks can potentially benefit from relaxation of Dodd-Frank, the Volcker rule or any other relevant regulation, which has been part of Trump’s campaign platform as well as the platform of House Speaker Paul Ryan.
In addition, bank stocks have been a “cheap asset and their earnings potential has improved dramatically because of amount of money on bank balance sheets,” says Lafferty.
Among the top-performing financial sector mutual funds, according to Morningstar, are John Hancock Regional Bank Fund (FRBAX), up over 22% year-to-date; Hennessy Small Cap Financial Fund (HISFX), up almost 19%, YTD; and Rydex Banking Fund (RYKIX), up close to 16%.
Another asset class likely to benefit from rising rates and higher inflation are bank loans, which are 60- to 90-day investment-grade floating rate loans. These assets “are even more compelling than high yield if rates are backing up,” says Lafferty, referring to rates rising, because they reset so frequently. Investors can now collect a 4.5% coupon without interest rate risk, says Lafferty.
Most of the bank loan mutual funds listed by Morningstar have year-to-date returns ranging from 5% to 12%.
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