Navigating the Uncharted Waters of the Fixed-Income Market

Moises Ospina, CIMA®, IMS Consultant
July 14, 2016

Central banks around the world have used monetary policy to stimulate economic growth.


Creating credit expansion via the commercial banks was part of a carefully crafted strategy by central banks, but so far stronger bank regulations and the profitability of commercial banks have been constraints on credit and growth expansion.

Lowering interest rates in tandem was a natural step for central banks in an effort to rebound from the financial crisis in 2008. The table below shows the two-year yield for government bonds around the world on June 27, 2016. The two-year U.S. Treasury traded at around 0.578 percent, while France, Germany, Sweden and Switzerland all experienced negative yields in the same time frame.

Source: Bloomberg

In a recent Bloomberg interview, Allianz Chief Economic Advisor Mohamed El-Erian said, “When you run an economy at low growth for a long time, strange things start to happen,”1 and we have seen a number of recent examples that verify his presumption.

Lower yields around the world are an indication of economies running at low growth for long periods of time, and negative yields could be interpreted as an act of desperation, a signal that central bank policy options to drive economic growth have proven to be ineffective.

So what happens when interest rates are close to zero or even negative? In the long run, lower and negative yields tend to harm business models — a classic example would be insurance companies. Insurers have long-term liabilities, and their models work if they can benefit on earning certain rates or interest in the long term. Bondholders can also get trapped in the dilemma that longer maturity bonds will deliver considerably higher levels of return — at least this is what’s expected in a normal yield environment. A closer look at the yields in the U.S. bond market will show that an investor could benefit from short- to intermediate-term bond positions in today’s economy.

As an effect of their monetary policies, central banks around the world might use tactics that would disrupt the market at some point in the future. The timing to reverse monetary policy will differ among central banks, and the process will be closely related to economic agendas. This behavior will cause currency volatility and unusual monetary imbalances.

Economies worldwide are recovering at different speeds from recent notable developments. For instance, the Federal Reserve recently signaled a raise in interest rates, while the main topic in the European Union (EU) was the possibility of Brexit, which resulted in the U.K.’s exit from the European Union.

Some investors and money managers have argued that yields should eventually return to normal levels. In an article for Barron’s, Janus Capital Fund Manager Bill Gross noted that “the Fed must normalize interest rates in coming years to keep the economy functioning properly.” 2 At the same time, Japan has been battling low yields for more than 30 years — the 10-year Japanese government bond was at 7.59 percent in 1984 and is currently at negative 0.19 percent. This means that an investment in a 10-year government bond, which is historically a relatively safe and stable investment, would provide you with a negative nominal return on your money. It’s also important to mention that, according to the World Bank, Japan went from a GDP of 7.1 percent in 1988 to a negative 5.5 percent in 2009. Lower and negative yields have close correlations to economies with endemic levels of growth.

Central bank monetary policies, along with uncertainty and irrational behavior from market participants, could ultimately flatten the yield curve in the U.S. and Europe. The historical model of raising interest rates to control inflation and lowering rates to invigorate the economy is no longer functional.


Source: www.tradingeconomics.com | Japan Department of Treasury

Outlining Your Strategy

Fixed-income products are sensitive to changes in interest rates — a rather unusual global economic environment with lower yields requires a deeper analysis of your needs and expectations from the fixed-income strategies.

The 1st Global Capital Markets Group works with affiliated financial advisors to position fixed-income portfolios in a challenging yield environment. We routinely analyze suitability, financial goals and special expenses (to name a few) before building fixed-income strategies.

Anticipating the timing and speed at which interest rates might rise is rather challenging due to possible monetary despair around the world. Our advisors strive to have a clear understanding of how fixed-income cash flows need to be deployed to cover your financial goals. In addition, we analyze changes on the Treasury yield curve to better understand potential cash flows between asset classes.

While we cannot control monetary policy, we can certainly have a positive impact on fixed-income strategies for our clients. The best strategy is the one that encompasses seamless communication between the advisor and the client and between the advisor and the Capital Markets Group to clearly understand the long-term financial goals and how the fixed-income asset class should fit in the overall allocation.

You are often overloaded with news, which makes it challenging to understand and anticipate monetary policy. Normalization of interest rates in a “new normal economy” 3 will take time, and uncertainty could lead investors to make irrational decisions.

It is important to emphasize that a well-crafted strategy is customized to fit your financial goals. Your advisor can always run an account analysis on existing individual bonds to make sure that the strategy is in line with your financial goals.

We constantly review the current yield curve to determine favorable spreads and opportunities, but the most important step in constructing a fixed-income portfolio involves outlining a well-defined plan with your financial advisor to create a suitable fixed-income strategy.

 

1El-Erian Links ‘Strange Risks’ Like Brexit to Faltering Economy.” Bloomberg June 20, 2016. http://www.bloomberg.com/news/articles/2016-06-20/el-erian-links-strange-risks-like-brexit-to-faltering-economy

2 “Bill Gross: Why Interest Rates Must Rise.” BARRON’S April 9, 2016. http://www.barrons.com/articles/bill-gross-why-interest-rates-must-rise-1460174700

3 PIMCO used the “new normal” term to describe an era of subdue returns and heightened government intervention. “Pimco’s ‘New Normal’ Thesis Morphs Into ‘New Neutral.’” Bloomberg May 13, 2014. http://www.bloomberg.com/news/articles/2014-05-13/pimco-s-new-normal-thesis-morphs-into-new-neutral-

 

Disclosures:

All opinions expressed and data provided are subject to change without notice.

Some of these opinions may not be appropriate to every investor.

Index performance does not reflect the deduction of any investment-related fees and expenses. It is not possible to invest directly in an index.

Asset allocation/diversification of your overall investment portfolio does not assure a profit or protect against a loss in declining markets.

Securities offered through 1st Global Capital Corp. Member FINRA, SIPC. Investment advisory services offered through 1st Global Advisors, Inc.

1st Global Capital Corp. is headquartered at 12750 Merit Dr., Ste. 1200 in Dallas, Texas 75251; 214-294-5000. Additional information about 1st Global is available via the Internet at www.1stGlobal.com.