By Bill Hornbarger, Chief Investment Officer at Moneta
As expected, the Federal Open Market Committee lowered interest rates for the second time this year on Sept. 18. The upper bound of the established range for the Fed funds rate now stands at 2%, down from 2.5% at the beginning of the year. The anticipation and result of these decreases are one of the contributing factors to the marked decline in bond yields experienced this calendar year.
Except for two brief periods, the benchmark 10-year Treasury yield has been less than 3% since mid-2011; real yields (adjusted for year-over-year inflation as measured by Consumer Price Index) have been very low as illustrated on the above chart and at some points negative during the same span. There are a variety of factors contributing to these conditions, many of which have been in place for several years and appear to be in place for the foreseeable future: approximately $15 trillion in global debt currently trades at negative yields, inflation and inflation expectations remain “low,” global monetary policy remains tilted towards accommodative and, demand for high-quality fixed income investments remains high.
While it is impossible to know exactly where bond yields will settle, we believe that they will remain roughly in the same ranges that they have been in for the past 10 years for the near and intermediate term. In that environment of persistent low (real and nominal) yields, what to do with one’s fixed income allocation remains the single biggest investment challenge for most investors.
Investors, portfolio managers and asset allocators have spent and continue to spend a considerable amount of time on this topic. High quality fixed income has traditionally been used in portfolios to generate income, provide equity market risk mitigation and provide liquidity while earning a return in excess of inflation. While the asset class will continue to provide the liquidity and asset allocation properties, it does so at a great cost–low nominal and real returns. This can increase other types of risks, such as shortfall risk for the portfolio.
What should an investor do in this environment? First, it is important to have a good understanding of risk and how much one is willing to take. To provide some perspective, the 10-year Treasury, which is widely followed and traded, recently yielded 1.77%. That is the 10-year “risk free” rate. To earn more than that amount, one must take additional risks. To earn appreciably more, one must take a commensurate amount of risk.
Additional thoughts on the bond market and interest rates:
- Most asset allocation methodologies have optimization at their core, solving either for risk or for return. In the context of very low bond yields, solving for a given risk level will result in a lower projected portfolio return; conversely, solving for return will likely result in a higher risk allocation. Regardless, we believe that this environment will result in portfolios tilting riskier in order for investors to achieve their goals.
- Many traditional yield-oriented strategies have relatively high correlations to equities and each other, particularly in times of crisis. High-yield bonds, real estate investment trusts, dividend-paying stocks and master limited partnerships all have higher risks than bonds. They all potentially have roles in a diversified portfolio, but sizing allocations and understanding their potential drawdowns is important.
- Over long periods, stocks have outperformed bonds. We do not expect this to change, and investors with long time horizons (who can also stomach volatility along the way) should be mindful of this.
- For core bond holdings, we favor the short to intermediate part of the yield curve (two years to as long as seven years). If the Fed continues to cut rates, shorter yields will fall with the Fed funds rate, and long yields will likely remain depressed and near cycle lows.
Persistent low bond yields are the investment challenge of our time. Fixed income still has very valuable attributes to add to a portfolio in terms of liquidity and risk mitigation. Unfortunately, in today’s environment, they come at a cost in the form of low returns. Hopefully that will change at some point in the future, but investors must plan around today’s low yields until they change. For investors still in the accumulation phase, adding diversifying asset classes, revisiting their financial plan and probability of achieving their goals, addressing spending and saving habits and actively monitoring risk in their portfolios are activities that have a heightened importance and increase the odds of a successful outcome. While there is no simple solution that offers higher, safe and relatively low volatility returns, Moneta can provide assistance with all of the aforementioned activities.
- U.S. Treasury yields fell across all maturities with the ten-year rate finishing at 1.5%. The yield curve further inverted with the two-year trading above the ten-year rates.
- All domestic fixed income sectors posted positive returns as markets showed strong consensus that the Federal Reserve would continue lowering interest rates.
- International-developed bond markets rose as global yields continued to fall. Emerging markets debt decreased in value due to U.S. Dollar strength.
- Domestic equities posted negative returns following a volatile month driven by amplified U.S. – China trade tensions.
- Growth broadly outperformed value during the month. Information technology, health care, communication services and consumer staples led while energy, financials and industrials lagged the benchmark.
- International equities fell on global growth concerns augmented by trade tensions. Emerging markets fell on U.S. Dollar strength and risk-off sentiment.
- Commodity prices fell due to livestock and agriculture oversupply, but were buoyed by gains made by precious metals on expectations of continued interest rate cuts.
- Domestic and international REITs generated positive returns influenced by falling interest rate expectations.
- Master Limited Partnerships (MLPs) underperformed as energy prices fell due to oversupply on the U.S. Gulf Coast and falling demand on U.S. – China trade fears.
Financial Market Performance
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