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Portfolio > Economy & Markets > Fixed Income

How to Invest in an Uncertain Bond Market

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A little over a year ago, the Federal Reserve raised short-term interest rates for the first time in almost a decade, indicating it would raise them four more times in 2016. But it didn’t raise rates again until last week, up 0.25%. And again the Fed indicated there were more rate rises to come: three more in 2017.

But could the market be getting ahead of the Fed again, setting the stage for rates to retreat from current levels, which are near 26-month highs? That’s a key question for advisors and investors trying to get a handle on the level of interest rates and strength of the bond market next year.

Ten-year Treasury yields are now near 2.6%, up about 20 basis points from a month ago and 35 basis points from a year ago.

The Case for Higher Rates

There is a case to be made for rates to rise further this year, which would naturally hurt bond prices. The U.S. economy is strengthening and inflation is rising, in large part because wages are increasing while unemployment sits at 4.6%, its lowest level since August 2007, and could fall further.

And the economy could potentially strengthen further if President-elect Donald Trump’s massive infrastructure spending plan materializes and more than offsets some other potential policy moves such as tariffs on imports, which could slow growth if exporters to the U.S. retaliate with their own restrictive trade policies.

The Case for Stable Rates

But there are also other countervailing forces beyond potential trade wars that could leave rates near where they are or limit their rise, including the strong dollar which could hurt U.S. exports as well as continued slow productivity growth and continued demand for U.S. bonds from overseas investors where rates are near or below zero. In addition, Trump’s infrastructure spending plan, if adopted, is not expected to make much headway before 2018, according to economists and strategists.

“To date we haven’t seen economic data that’s particularly inflationary,” says Brett Wander, chief investment officer of fixed income at Charles Schwab.Until we do the Fed will be cautious” and “rates could stay where they are or decline.”

Much of the uncertainty about the U.S. economy and interest rates rests with the incoming president the first one with no experience in elected office, the military or public service of any kind — and the Republican Congress.  

The Potential Impact of the New President & Congress

“The bandwidth of possibilities is enormous,” says Wander. “We’re in the midst of something so fundamentally unknown. The market assumes significant changes in regulation, taxation and fiscal spending.” Such policies are easy to talk about but can be difficult to get done, according to Wander.

Richard Bernstein, CEO of Richard Bernstein Advisors, admits that even though Trump’s actual economic package might not match what he promised during the presidential campaign, “It seems reasonable to assume there [will] be more fiscal stimulus rather than less and that the positives of fiscal stimulus will be greater than the potential negatives from the normalization of monetary policy an rising rates.”

Such fiscal stimulus will likely encourage the Fed to tighten “somewhat more aggressively,” says Jim O’Sullivan, chief U.S. economist at High Frequency Economics.

Most economists and strategists expect the Fed will raise rates gradually in 2017, depending on the economic data, with the federal funds rate ending the year between 1.5% and 2.0% and the 10-year Treasury note finishing somewhere between 2.5% and 3%. GDP, adjusted for inflation, is expected to grow around 2%.

Forecasting Fed Rate Hikes in 2017

“The market is pricing in 2.5 Fed rate hikes,” says John Pattullo, co-head of strategic fixed income at Henderson Global Investors, who’s expecting most likely just one. “There’s more chance of one than three hikes.”

Tom Siomades, head of Hartford Funds Investment Consulting Group, agrees that three rate hikes in 2017 is unlikely. “Q4 2016 and Q1 2017 GDP would have to be in the 3.5% range for that forecast to stick.”

Given these uncertainties coupled with moderately rising inflation market strategists are recommending that investors not stray too far out the yield curve, maintain durations generally under five, and be nimble and diversified.

Bond Strategists’ Recommendations

“Short duration remains the primary theme within our fixed income holdings,” writes Bernstein in his 2017 outlook report.

“This rate cycle will be more difficult than the last,” writes David Kelly, chief global strategist at J.P. Morgan Asset Management. “Rates are rising from extraordinary low levels and fixed income investors will not have the buffer of juicy yields that they enjoyed in past cycles to protect  against capital depreciation as rising rates lead to falling bond prices.”

Kelly suggests “a creative and nimble approach to fixed income investing” that includes “high-quality core” securities as well as” less rate-sensitive sectors such as high yield.”

State Street strategists recommend, in addition to core assets providing stability and income, floating rate securities over fixed, including senior loans, to take advantage of rising rates. These are short-term bank loans to businesses rated below investment grade that have adjustable rates and are senior in the capital structure of a company and secured by corporate assets. They currently yield between 5% and 6%.

Senior loans “may benefit more in an era of rising rates and elevated defaults than fixed-rate high yield,” according to State Street.

U.S. Treasury inflation-protected securities (TIPS) are another type of bond that can benefit from rising inflation.

“Anyone looking to mitigate inflation risk while remaining invested in high-quality bonds could consider inflation-protected bonds,” write analysts at UBS. Their bullish inflation outlook is based on rising wages, stable oil prices and Trump’s expansionary fiscal policy coupled with potential tariffs and curtailed immigration. “The market is underpricing inflation.”

Maybe in the long term but not in the short term, according to BlackRock strategists. They “have a long-term preference for inflation-protected securities but see short-term risks as the markets appear to have gotten ahead of themselves.”

Merrill Lynch strategists are more bullish on high-grade corporate bonds. “Total returns in 2017 will likely be a sobering 3.5% to 4.5% for U.S. high grade bonds and 4% to 5% for U.S. high yield…. Our preferred asset class is U.S. high grade where the dropoff in supply could be very bullish.”

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