Bond Outlook: Lower for Longer, But Not Forever (Kathy Jones, et al)

March 8, 2013

by Kathy A. Jones, Vice President, Fixed Income Strategist, Schwab Center for Financial Research
and Rob Williams, Director of Income Planning, Schwab Center for Financial Research
and Collin Martin, Senior Research Analyst, Fixed Income and Income Planning, Schwab Center for Financial Research

Lower for Longer, But Not Forever

We've been in the "lower for longer" camp for quite a while, based on our view that sluggish economic growth, tightening fiscal policy, and the Fed's easy monetary policies would keep interest rates low for an extended period of time. However, we've become more cautious about holding long-term bonds over the past year, due to our concern that the risk of being caught in an unexpected sharp rise in interest rates was worse than giving up some of the potential capital gains to be had as bond yields fell to new lows. We are not market timers and we still believe that laddered portfolios with average durations1 in the intermediate term range make sense for many bond investors. But we are often asked: what will change our view on interest rates? The following is a short description of what we're watching.

• Follow the money, jobs and the Fed. We look for bond yields to move up when the economy is strong enough to generate more jobs and income growth. We think it's surprising how many forecasters have been looking for interest rates to "normalize" before those things happened. We don't believe that there is a set of "normal" interest rates. There are long-term averages and historical relationships between interest rates and economic fundamental factors. These are useful, but we also have to factor in all of the "abnormal" factors—such as the Fed's zero interest rate policy and quantitative easing program, the unfinished de-leveraging cycle in the developed world and demographic trends. We think the three key factors to watch are the growth rate in money and lending, employment and Fed policy.
• Money and Lending. Since the onset of the financial crisis, the Fed has created an unprecedented level of reserves in the banking system. However, the demand for money was relatively soft until last year. Stronger demand for money tends to lead to higher interest rates and stronger spending may lead to inflation. The pace of lending has picked up and as a result, nominal GDP growth, which tends to track credit growth, has picked up as well. But both lending and nominal GDP are still growing at rates near the low end of the long-term trend. That suggests a relatively slow pace of real GDP growth, in the 2% to 2.5% region, which is what it has averaged since 2010.

Credit Growth and Nominal Gross Domestic Product (GDP)

Note: Nominal GDP is gross domestic product (GDP) figure that has not been adjusted for inflation.
Source: St. Louis Federal Reserve Bank Credit of All Commercial Banks (TOTBKCR), and Gross Domestic Product (GDP), percent change from year ago, seasonally adjusted. Data as of December 31, 2012.

• Jobs and Income. In the U.S., where 70% of GDP is attributable to consumer spending, we see jobs and income growth as important factors to watch. Since 2007, when job growth declined and median household incomes flattened, consumer spending has slowed to an average annual growth rate of 1.9% compared to a 3.5% annual pace for the 25 years prior to the financial crisis. We are watching for unemployment to fall to a level where average hourly earnings and household incomes begin to rise again. Since the end of the recession in June 2009, job growth has been among the weakest of all post WWII recoveries. It could take more time.

Median Household Income in the U.S. 1984 to 2011

Source: U.S. Census Bureau, Current Population Survey, Annual Social and Economic Supplements. Last revised on June 8, 2012.

• The Fed. Not surprisingly, the Federal Reserve's policy of anchoring short-term interest rates at zero and buying long-term bonds is an important component of our interest rate outlook. Recent comments from some Fed officials indicating concerns about the long-term adverse affects of quantitative easing may be the first hint that policy will be changing. However, Fed Chairman Bernanke and Vice Chair Yellen, along with NY Fed President Dudley, all permanent voting members of the Federal Open Market Committee (FOMC), are still in favor of quantitative easing, and the majority of the committee has voted in favor of their policies since the financial crisis began. The Fed's official stance is that they will continue quantitative easing until unemployment falls to 6.5% with inflation in the 2.0% to 2.5% range. We are listening for any shift in policy stance by Chairman Bernanke to signal a change in the interest rate outlook.
• Bottom line. We are still in the "lower for longer" camp but don't expect to be there forever. We continue to favor a relatively cautious stance of reducing average duration to an intermediate-term range (5-10 year maturities, on average) based on our view that risk/reward for long-duration bond portfolios is unattractive.

What Drives the Corporate Credit Market?

Investment grade corporate bonds have benefited over the past four years from declining bond yields and tightening of spreads to Treasuries. High prices and falling average coupons may make it difficult to repeat the strong returns that corporate bonds have generated over the past few years. But it seems that the risk of rising interest rates—not just on corporate bonds, but most fixed income investments—has been on everyone's minds lately. We'll discuss how corporate bonds have tended to react in rising rate environments, and some points to consider when holding, or adding to, corporate bond positions.

• What drives corporate bond performance? Investors often discuss "the bond market" and the risk that rising interest rates have on bond prices. But there is no one "bond market"—not all bonds are the same and there can be various reactions to rising rates. Corporate bond yields include a credit spread, which is additional yield above a Treasury with a comparable maturity, to compensate for the risks holding a corporate bond, such as the risk of default. So evaluating corporate bonds means looking at both Treasury yields as well as the potential for changes in the additional yield received from a corporate versus Treasury bond.
• Credit spreads tend to fluctuate based on market conditions. Credit spreads can be thought of as compensation for taking on the credit risk of owning a corporate bond. Spreads tend to fluctuate based on a number of factors, including the outlook for economic growth. If economic growth is expected to be strong, investors may be willing to accept a lower credit spread since the risk of default may be lower. If growth is expected to slow, the opposite may occur.
• Rising interest rates have tended to lead to tighter credit spreads in the past. We think that any significant rise in rates will be the result of a stronger economy, which may lead to tighter credit spreads. This can help offset the risks that rising rates have on the price of fixed coupon bonds. If Treasury yields rise by 20 basis points, for example, but credit spreads decline by 20 basis points, the result would be no change in yield for corporate bonds, all else equal. While Treasury bond prices would fall, corporate bond prices may not since their yields remained constant. Looking at the table below, we see that recent periods of rising rates have led to lower spreads. We would point out that rising Treasury yields can, and often do, lead to negative total returns for investment grade corporate bonds, but it can lead to outperformance relative to securities that don't have credit spreads.

Over the Past 10 Years, Rising Bond Yields Have Typically Been Accompanied by Tighter Credit Spreads

Note: Excess Return is the curve-adjusted excess return of a given index relative to a term structure -matched position in Treasuries. The calculation method depends on the index type. A portfolio, for example, may have an excess return above the index on which it is based. It is important to note that receiving an excess return almost always requires one to take on more risk.
Source: Barclays, Bloomberg and the Schwab Center for Financial Research. 10-year Treasury yield represented by the U.S. Generic Govt 10 Year Yield Index (USGG10YR). The corporate sector is represented by the Barclays U.S. Corporate Bond Index. Past performance does not guarantee future results.

• Credit spreads are at their long-term average. But corporate fundamentals overall remain strong and default rates remain low, so we think there could be room for spreads to decline. In fact, the speculative grade default rate, according to Moody's, has come down since the highs reached during the financial crisis and has been under the 20-year average for the past two and a half years. The spread of the Barclay's U.S. Corporate Bond Index is roughly 1.4%, or 140 basis points. Although we don't think they will approach their all-time low of 51 basis points anytime soon, there is room for compression.
• The Bottom line. We think that tighter credit spreads could help offset some of the interest rate risk in corporate bonds if Treasury rates rise. But investment grade corporate bonds can still generate negative total returns in a rising interest rate environment. This don't necessarily mean corporate bond investors need to rush for the exits, but we think it's important to know how various asset classes may react, and try to be positioned accordingly.

Sequestration's Impact on Muni Markets

A "new era" of federal austerity has arrived, as Congress debates spending cuts and allows sequestration—a series of across-the-board automatic spending cuts—to go into effect. Federal budget reductions will be a part of both the short- and longer-term revenue climate for municipal governments, in our view, whether sequestration takes effect in its current form or renegotiated into a series of more targeted reductions. For investors in muni bonds, here are some points to consider.

• Federal money makes up 34% of total state spending, according to the National Conference of State Legislatures. This seems like a large proportion of state budgets, but the money is spread out widely across a mix of mandatory and discretionary programs. Medicaid is one large federal program where there is a significant cross-over with state spending. Medicaid has been explicitly exempted from sequestration, however, lessening the potential impact on state budgets.
• The impact by region and state will vary. The importance of federal grants by state varies, however, as does the potential impact of reduced federal spending in individual states and municipalities. The Pew Center on the States has published a useful interactive map estimating grants subject to sequester, by state, as a percent of revenue. The sequester may also be temporary, replaced by a long-term package of more targeted budget cuts.
• Reduced federal spending will be a drag on economic growth in the short-term, in our view. Federal employment drives 5% of economic activity nationally, according to the Pew Center Data. But in D.C. and surrounding areas, it drives 20% or more of local employment. Lower federal spending will also likely reduce national GDP growth in the short-term, in the consensus view of economists, leading to lower rates for longer from the Federal Reserve, transferring through to rates on other investments including muni bonds.
• Moody's outlook is negative on 4 Aaa-rated states and 40 local governments based on links to the federal government. Moody's rationale for these negative outlooks relates more to their assessment of the connection between these governments and the credit quality of the U.S. government, not directly to sequestration, according to Moody's commentary. If the U.S. Aaa rating is lowered, the ratings on these states and municipalities could be lowered also. States with Aaa ratings but negative outlooks include Maryland, Missouri, New Mexico and Virginia.
• Standard & Poor's has said that they expect the impact to be "uneven" across sector. Each government will manage this "new era" of reduced federal funding differently, in their view, just as they adjusted to 2008/09 recession and other threats to credit quality. They anticipate that the effects of sequestration will be "mildly negative in broad terms," with potential for more impact in specific credits or jurisdictions. But "with only a few high profile exceptions," state and local governments have made cuts to preserve credit quality.
• Sector views. Local municipalities and school districts may face decreased federal grant funding for education programs and public safety. Airports and ports may face operational cuts and layoffs. Essential-service infrastructure providers, such as water and sewer systems, generally rely on user charges than federal funds for operations, so they may be less impacted. Medicare reimbursements to doctors and hospital will be reduced 2%, potentially impacting not-for-profit hospitals. Issuers in the higher-education sector may face reduced grant funding, though most are not reliant on these funds for debt service payments or operations.
• Bottom line. Despite of threat of less support from the federal government, most states, municipalities, and other issuers in the muni market will adjust to the "new era" of reduced federal spending, in our view. The impact is another bump in the road for municipal issuers. But we don't suggest a change in strategy for investors holding well-diversified muni portfolios at this time.

Short-Term Bonds If You Think Rates Will Rise

The most common question we hear from investors is the risk to bond investments if interest rates rise. The second most common question is will bond returns keep up if we see inflation down the road. Repeating a theme, it depends on bonds you hold, in our view. An allocation to short-term bonds—meaning bonds or bond funds with shorter maturities—make sense to us if you worry about if and when rates rise—or if we see higher inflation longer-term. Here are our thoughts to explain our view.

• The value of short-term bonds or bond funds is less sensitive to the risk that rates rise. Two factors tend to matter most when looking at risk in bonds: the level of credit risk (the risk of not getting repaid) and the level of interest rate risk (how long it takes to be repaid). The shorter the maturity of a bond or the average maturity of bonds in a bond fund, generally the lower the interest rate risk, all else being equal. Short-term bonds or funds—which we define as having a single (or average) maturities between 1-5 years—are generally less sensitive than intermediate or long-term bonds, for shorter periods of time, if rates rise.
• Short-term bonds can be reinvested more quickly than long-term bonds. As a result, investors should be able to take advantage of the higher rates more quickly. For income-oriented investors, it may be helpful to have some money available and ready to reinvest when rates are more attractive. A short-term bond ladder with maturities from 1-5 years or a short-term bond fund can meet this objective.
• The Fed will likely increase short-term interest rates if inflation rises above 2.5%. The common wisdom says that short-term bonds will never keep up with inflation. That's likely true over long time periods. But it may not be the case during periods when inflation rises quickly. If inflation rises at a rate above 2.0% to 2.5% annually, the Fed has said that it would raise short-term rates. In the late 1970s and early 1980s, when inflation (as measured by the year-over-year change in CPI) was rising rapidly, rates on cash investments and short-term bonds rose quickly, as shown in the chart below. Short-term rates fell in close relationship with inflation thereafter.

Rates on Cash Investments and Short-term Bonds: 1978-2013

Note: Yield to Worst is defined as the lowest potential yield that can be received on a bond without the issuer actually defaulting.
Source: Bureau of Labor Statistics, Bloomberg, and Federal Reserve. Data as of March 1, 2013.

• Keep an eye on duration—or average maturity. Duration is a way to measure, and monitor, interest rate risk, and is generally related to the bond's time to maturity. A rule of thumb is that an existing bond or fund would be expected to fall in value by the duration multiplied by the change in interest rates. A bond (or fund) with a duration of 5 might fall 5% in value if interest rates rose 1%. Schwab clients can look at the distribution of maturities, which is generally slightly longer than duration, of their fixed income portfolios by logging in to Schwab.com, then navigate to Guidance > Tools > Portfolio Checkup. Then click on the Fixed Income tab. For the duration of an individual bond or bond fund, talk with as Schwab Fixed Income Specialist at 877-563-7818.
• We suggest a mix of short-term and intermediate-term bonds or funds. A bond ladder mixes bonds maturing soon with some maturing later. We prefer ladders with maturities maxing out at about 10 years, for most investors. For investors who prefer bond funds, consider a mix of funds that fall into Morningstar's "short-term bond" category for shorter term needs (money needed within 1-5 years) combined with "intermediate-term bond" funds for higher potential income earned on principal that isn't needed soon.
• Bottom line. Risk in the bond market depends on where you invest. For investors worried about rising interest rates and/or inflation, short-term bonds or bond funds may fall in value if rates rise. But they are generally less sensitive to interest rate risk, for a shorter period of time, than longer-term bonds, all else being equal. For this reason, they should play a part in your bond strategy, in our view, in a low rate environment.