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Financial Planning > Tax Planning > Tax Reform

The Low-Yield Bond Market Is Back

By Bernice Napach

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Advisors who have been counseling investors to prepare for rising rates and rising inflation may want to revisit those expectations. Despite forecasts for higher rates following the U.S. presidential election, the yield on the 10-year Treasury today is the same as the yield in mid-November, before two Fed rate hikes, the last CPI report showed prices falling for the first time in more than a year and crude oil prices have slipped below $50 a barrel.

(Related on ThinkAdvisor:  Fed’s Fischer Says Two More 2017 Hikes Still Feels Right)

The paradigm shift in the bond market that many strategists have been expecting since even before the election of Donald Trump as president has not taken hold.

(Related on ThinkAdvisor: Trump’s Election Fuels ‘Paradigm Shift’ in Bond Yields, Inflation Outlook)

The Fed is still expected to raise rates later this year – a point that its Vice Chair Stanley Fischer reinforced on Friday – but even those expectations have softened. The CME’s FedWatch tool, which measures market expectations for Fed rate hikes, is now showing odds of less than 50% for a rate hike in June.

Investors may also remember that Fed officials had forecast four hikes for 2015 and 2016 but raised rates only once in each of those years.

“There’s still a greater risk of deflation than reflation,” says Gary Shilling, founder and president of A. Gary Shilling & Co., an economic research and money management firm. Less inflation means less reason for the Fed to raise rates.

“The initial reaction to the election was a rally in oil, the U.S. dollar and stocks including emerging market stocks. But Trump hasn’t gotten anything through Congress on tax cuts or deregulation yet, and infrastructure projects take years.”

(Related on ThinkAdvisor: Trump’s Tax Plans Coming Next Week, White House Official Says)

In an interview with The Associated Press on Friday, the president said he plans to unveil his plan to cut personal and business taxes on “Wednesday or shortly thereafter,” just before marking his first 100 days in office.

He offered no details about the plan and it’s not known how Congress will react, especially if Trump insists on first replacing Obamacare before tackling tax reform, which could delay any action on tax reform. (House Speaker Paul Ryan last month pulled a repeal-and-replace plan just before a vote on the House floor because he didn’t have the votes to pass it.)

Even if Congress moves on tax reform as well as financial deregulation and an infrastructure spending plan, it could take months, if not years, for these changes to take effect, which leaves advisors facing many of the same investment challenges today that they faced before the election, including low yields that don’t provide adequate income for clients.

They may be tempted to stretch for yield in client portfolios by moving out on the yield curve into longer term debt, which comes with increased interest rate risk, or by buying lower quality paper, which increases credit risk.

Also, beyond the uncertainties about growth, government policies and Fed rates is the issue of the $4.5 trillion Fed balance sheet, which Fed policymakers expect to begin reducing, according to the minutes of the last meeting of the Federal Open Market Committee.

“If we hear more about the Fed reducing its balance sheet there will probably be some upward pressure on the long end of the curve,” says Kathy Jones, chief fixed income strategist at the Schwab Center for Financial Research, but she says there’s “probably more upside than downside risk” for the bond market overall.

“We’re still in a 2% world,” says Jones, referring to GDP growth that has averaged 2% since the recession. (The first reading on first-quarter GDP will be released April 28.) Jones is cautious about the bond market. She favors short- to intermediate-term high-quality bonds and recommends against riskier bond assets such as high yield. “There’s not a lot of premium in riskier parts of the bond market.”

Lon Erickson, bond portfolio manager at Thornburg Investment Management, says it’s important for investors to understand both the rate risk and credit risk of bonds, and many are not focusing enough on the latter. 

Trading one risk for another doesn’t necessarily reduce risk. For example, says Erickson, if the credit spread on a five-year bank loan rises from 2.5% to 4.5%, the loss from that credit downgrade is roughly equivalent to the loss in a five-year Treasury note if interest rates move from 1.74% to 3.74%.  Moreover, says Erickson, the Treasury risk is temporary – if held to their full term the bonds will mature at par – but the credit risk can result in a permanent loss.

“Know the risk you’re taking and make sure you’re appropriately compensated,” says Erickson.

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