AAM Viewpoints: Both Investors and Led Zeppelin Ask, “Hey, Hey What Can I Do?”
Kindly pardon the attempted puns and my artistic license at applying Led Zeppelin song titles to the following commentary.
“Dazed and Confused” – Led Zeppelin (1969)
During a meeting with a handful of financial representatives in early January, with the underlying context of a flat yield curve, the single most relevant question on their collective minds was, “What should fixed income investors do with regard to their current and future investments?”
“Ten Years Gone” – Led Zeppelin (1975)
First, let’s provide some context to the current interest rate picture. Ahead of The Great Recession the Fed embarked upon an aggressive rate-cutting campaign from its higher target rate of 5.0 to 5.25%. Thereafter, the Fed maintained its lowest possible target rate of 0 to 0.25% from December 2008 until December 2015, at which point Chair Yellen subsequently began a campaign of rate hikes resulting in the target rate arriving at our current 2.25 to 2.50% level. As demonstrated in the below chart, the effect upon the interest rate curve as the Fed raised its target rate is unmistakable.
The U.S. Treasury Yield Curve flattened as front-end rates rose significantly more aggressively than longer term interest rates. Since the federal funds rate is – by definition – an overnight rate, its influence was most directly and impactfully observed on the short end of the interest rate curve. For several reasons, not least of which remains the Fed’s enormous inventory of long-dated paper due to Quantitative Easing that is simply sitting on their balance sheet, the long end had little reason to adjust higher.
“What Is and What Should Never Be” – Led Zeppelin (1969)
Over the past three-year period, as the Fed raised its target federal funds rate, too many investors were mistakenly locking in short-term interest rates with purchases of short-dated paper. Their concern was that interest rates would rise in a parallel fashion as opposed to the reality of a flattening curve with the front end underperforming the long end. We emphatically cautioned against this very mistake as investor performance was compromised and intermediate-term investments correctly provided some ballast to portfolios without the potential risk of long-dated securities and underperformance of shorter-dated securities.
“The Song Remains the Same” – Led Zeppelin (1973)
Since that meeting with Financial Representatives in early January, Chair Powell introduced a decidedly more dovish tone to the Fed’s outlook with a “pause” to its rate hike campaign. Interest rates have been stagnant and stuck in a very narrow range within some technically relevant boundaries. Therefore, the question posed in that meeting is still as equally relevant within a similar market context.
“Ramble On” – Led Zeppelin (1969)
Chatter about an inversion of the yield curve, including from yours truly, has died down as the threat of imminent hikes by the Fed no longer present the same threat to short-term rates. Since an inversion of the yield curve is a potential indicator of a recession within one to two years, a decreased likelihood of its occurrence allows investors some respite and from worrying about this danger to the U.S. economy.
“Good Times Bad Times” – Led Zeppelin (1969)
Some things we believe investors should seriously consider with their existing investments would be to upgrade credit quality. Across asset classes, credit spreads have narrowed to some of the tightest levels over the past 20 years. Furthermore, the concentration of lower grade investments as a percentage of outstanding debt is at the highest in history. Specifically, BBB-rated credits comprise over 50% of outstanding corporate debt for the first time ever. Despite this fact, demand for yield remains robust. Typically, in an economic downturn, 10% of such credits decrease in credit rating (and therefore price) into high-yield/junk status. If I had a nickel for each time I’ve recommended investors take some of their proverbial chips off the table and then had a follow-up discussion about their failure to do so I’d be writing from my own Caribbean island. In short, we believe investors should take advantage of the run-up in prices along with narrow credit spreads for the potential to lock in returns and minimize future underperformance.
“Stairway to Heaven” – Led Zeppelin (1971)
As for future investments in the environment in which we find ourselves, we still find the best overall risk/reward dynamic in the intermediate range of the curve. Specifically, the seven- to 15-year portion of the maturity spectrum is the steepest part of the curve and provides ample yield pickup over very short-dated paper. Furthermore, with the Fed’s patient approach to future hikes, there is potential for some yield curve flattening and this portion of the curve would benefit. Regardless, even if interest rates in this portion of the curve fail to move appreciably, the additional yield available in this range has the potential to help total return performance over the much shorter portion of the maturity curve.
This commentary is for informational purposes only. All investments are subject to risk and past performance is no guarantee of future results. Please see the Disclosures webpage for additional risk information at commentary-disclosures. For additional commentary or financial resources, please visit www.aamlive.com.