Federal Reserve Copyright Chip Somodevilla, Getty Images

Why Rising Rates May Not Lift Your Income

The link between Fed Reserve rate hikes with long-term interest rates and investment income is often weak at best.

By Mike Kelly

The start of any new year can foster hopes for a brighter future—and 2018’s was no exception. The year kicked off with buoyant global growth expectations, giving the Federal Reserve’s rate hike cycle firmer footing and interest rates a modest lift. This sparked hopes that the long income drought may be ending. Yet the link between Fed rate hikes with long-term interest rates and investment income is often weak at best. Higher policy rates have only a fleeting positive impact on traditional fixed income investments. The upshot? Investors looking for income streams to “renormalize” across traditional fixed income asset classes are likely to be in for a longer wait.

Growth and Inflation Expectations on the Move

No one would blame investors for feeling recent years left them lost in a low-yield wasteland. The lowest interest rates modern markets have ever seen have been dominating the financial landscape since the Great Recession, with the federal funds rate resting at zero for 7 years and the 10-year Treasury trading as low as 1.36 percent in 2016.While equity markets raced higher during the 9-year bull market, most major interest rate benchmarks remained anchored at or near historic lows.

Investors are still awaiting a great renormalization that would bring income generation back to levels seen during the 1990s or 2000s. And 2018 has sparked hope that this process is underway. After all, economic data shows improved output and soaring confidence measures. Pro-growth policies on tax cuts and fiscal spending are stoking optimism. Economists and policymakers, in turn, are revising their GDP forecasts higher, causing inflation expectations to rise.2

Such good economic news is strongly impacting the expected Fed rate hike trajectory. Over a 6-month span, the Fed’s growth forecast stood at 2.1 percent.3 Today it’s at 2.7 percent.4 Markets have gone from pricing in 44 basis points of rate hikes to 107 bps by the end of 2019.5

The Weak Connection Between Rate Hikes and Long-Term Yields

On the surface, the connection between rate hikes and an improvement in investor income seems straightforward. When the Fed sees growth that’s outpacing the economy’s underlying potential, particularly when the unemployment rate is already low, it raises rates. But how this connects to investor income is more complicated.

The federal funds rate is an overnight interbank lending rate that investors never actually use, but it is the main driver of short-term interest rates like LIBOR and Treasury bills. At longer maturities, where investors typically look to harvest income, there are multiple competing factors that can influence yield. 

When the Fed engages in a typical rate hike cycle, the 10-year Treasury—the traditional bellwether for most income-oriented investors—often gets little to no boost from even dramatic rate increases.

The Way Forward in the Search for Income

For those seeking income from traditional investments, these yield-curve acrobatics can seem almost counterintuitive. For example, investment grade corporate bonds currently yield approximately 3.99 percent, only 34 bps more than when the Fed began raising rates,6 while high-yield bond yields are 2.54 percent below where they were when policy rates started rising.7

Traditional fixed income investors face yet another challenge. The higher an investment’s duration, the more its value is impacted by even a small increase in interest rates. In January 2009, the duration of the Barclays Agg, an investment grade bellwether, was 3.5. That has since risen to 6.1, putting the index value at risk should rates rise even a small amount.

We don’t expect interest rates to surge higher, but if they do, bond funds that have a meaningful allocation to high-duration assets will likely see their value eroded, offsetting benefits gained from slightly higher income.

Combine all of these factors and the prospect that traditional income streams will renormalize soon seems unlikely. This leaves income-seeking investors with a few options. They may continue to wait in the hopes that income will renormalize as short-term rates rise. They may add or increase allocations to nontraditional fixed income asset classes, such as commercial real estate or private debt. Investing in floating rate senior secured loans is another option—one that comes with a potential hedge against rising interest rates. They may invest in strategies designed to benefit from market ups and downs. Historically, markets have been subject to periods of significant volatility when the Fed begins tightening. Simply put, investors should keep an eye on rising rates while constructing a portfolio to weather an uptick in volatility and a longer income dry spell.

Passively waiting for interest rates to rise likely won’t be enough. To best access alternative strategies for their client’s portfolios, advisors can:

  • Look beyond traditional fixed income asset classes. Large institutions have long turned to asset classes such as real estate and private debt, which in exchange for liquidity, may offer alternative sources of income. Individual investors may also benefit from investing in these asset classes.
  • Look to floating rate loans. Leveraged loans have been the beneficiary of higher short-term rates and have returned 2.05 percent this year, compared with -3.42 percent and -0.26 percent for investment grade and high-yield bonds, respectively.8 While higher returns may be accompanied by increased risk, floating rate senior secured loans have drawn significant interest this year as investors have increasingly looked for a potential hedge against rising interest rates.
  • Seek investments that are less correlated to the broader market. Though even a diversified portfolio can experience loss during market downturns, certain alternative strategies display low levels of correlation to traditional stock and bond investments.

End Notes

  1.  Bloomberg yield quote, July 7, 2016.
  2. The 5-Year, 5-Year Forward Inflation Expectation Rate, a common market proxy for inflation expectations, rose from 1.87 percent on Nov. 15, 2017 to 2.27 percent on April 30, 2018 (Bloomberg).
  3. Federal Reserve Economic Projections, September 2017, median 2018 GDP forecast.
  4. Federal Reserve Economic Projections, March 21, 2018, median 2018 GDP forecast.
  5. Bloomberg pricing of December 2019 Fed funds futures curve, as of May 24, 2018.
  6. ICE BofAML U.S. Corporate Index was 3.65 percent on Dec. 15, 2015 (Bloomberg). 
  7. ICE BofAML U.S. High Yield Index was 8.86 percent on Dec.15, 2015 vs. 6.32 percent on May 24, 2018 (Bloomberg).
  8. Data from Bloomberg, May 24, 2018. Investment grade bonds represented by the Bloomberg Barclays U.S. Aggregate Bond Index. High-yield bonds represented by the ICE BofAML U.S. High Yield Index. Leveraged loans represented by the S&P/LSTA Leveraged Loan Index.

 

Mike Kelly is President and Chief Investment Officer at FS Investments.

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