Federal Street Advisors
Intro:
While macroeconomic news out of China, and the price of oil
has dominated the most recent financial market headlines, the U.S. Federal
Reserve policy has been a subject of debate and intense focus for years. Investors, bankers, economists and
reporters alike are fixated on every word the Federal Reserve and its board of
Governors releases. The
examination of, and some might argue obsession with, Fed statements has reached
a point where the market can rapidly change direction based on just an
alteration of word choice, even when the overall message remains the same. These statements garner so much
attention because traders and investors are trying to gain an edge in
predicting when interest rates will rise. Setting aside the debate on when the exact date of an
interest rate hike might be, this paper examines what rising rates mean for
your investment portfolio and argues that the long-term benefits are something
investors should welcome not fear.
In order to examine this in detail, we first must have a good
understanding of how the Federal Reserve works and why its policy affects
interest rates.
What is the US
Federal Reserve and why does it matter?
The U.S. Federal Reserve Bank (commonly referred to as the
Fed) is the central bank of the U.S. financial system and its primary function
is to enact monetary policy that helps to stabilize and improve the U.S.
economy. The Fed’s three main
objectives are: to maximize employment, keep prices of goods stable, and
moderate long-term interest rates. As the economy goes through cycles from economic booms to
recessions, the Fed takes action to moderate the booms and minimize the
probability and depth of recessions. One of the key tools the Fed uses to keep the economy stable
is interest rates. In this case, interest rates reflect the yield paid to buyers
of U.S. Treasury bonds. The Fed
can influence the level of interest rates by buying large quantities of Treasury
bonds on the open market, thereby pushing prices of the bonds up and yields
down and vice versa. In general,
the Fed will increase interest rates in order to slow down the economy and
decrease them to stimulate growth.
Why do investors fear
rate increases?
Investors have feared the prospect of rising interest rates
for two main reasons: the potential for slower economic growth and negative
returns for bonds. The Federal
Reserve uses higher interest rates to slow the economy by increasing the cost
of doing business and buying a house. Companies looking to build a new factory or invest in new
technologies often raise funds for these projects by issuing bonds. As interest rates rise on Treasury bonds
they rise correspondingly on corporate bonds, increasing the cost of financing
for companies. As the cost of
financing increases, companies are less likely to invest in new projects,
slowing the economic growth rate of the economy. Similarly as interest rates rise on Treasury bonds, the
interest rates for mortgages on homes also rise. This increases the monthly payment required to build or own a
home, subsequently slowing the pace of growth in the housing market. While we think this is a legitimate
concern in the long run because slowing economic growth can act as an
impediment to earnings growth and stock prices, at this point in the interest
rate cycle the effects should be limited.
Interest rate changes don’t just affect the economy; they
can also have sudden and material impacts on performance of investment
products. Interest rates and the
prices of bonds have an inverse relationship, as rates rise bond prices fall
and vice versa. During the past 30
years, investors have enjoyed a long cycle of declining interest rates. In September of 1981 the 10-year Treasury
Bond peaked at an interest rate of over 15%. Since then, interest rates have been steadily declining,
producing an environment of sustained strong performance as bond prices rise. The U.S. Barclays Aggregate Index has delivered
an annualized return of nearly 8% over that time span, with only a few short
periods of mild negative returns, conditioning investors to expect strong
consistent positive returns in fixed income. Many fear that when the Fed changes its policy and begins to
raise interest rates, negative bond returns will cause widespread selling of
fixed income products causing further declines in bond prices. This concern is certainly warranted and
we have positioned our clients’ portfolios to protect against this risk, however,
we continue to believe that higher interest rates is a healthy outcome for
investors and the market in the long-run.
What are the
benefits?
At Federal Street Advisors, we believe that rising interest
rates do present real near-term risks that investors should be prepared for but
recognize that higher interest rates will also bring long-term benefits to
those who are well positioned. Higher
interest rates are an indication of economic strength, improve income available
for investment products, and promote rational capital markets.
While the Federal Reserve does use higher interest rates to
slow economic growth late in a business cycle, it is important to understand
that the potential upcoming interest rate hike is not an attempt to slow growth
but rather to return interest rates rate to a normalized level. During the financial crisis of 2008/2009,
the Federal Reserve lowered their interest rate policy target effectively to
zero where it has remained since then. This was a historically extreme measure designed to promote
business investment, stabilize the housing market, restore confidence in the
stock market and stimulate economic growth. The Federal Funds target interest rate (the interest rate
that the Fed targets for monetary policy) has been 0%-0.25% since December 16th,
2008, well below its long run average of 7.4%1. An increase in the Fed’s target interest
rate today would be indicative of their confidence in the economic strength and
stability as they seek to bring interest rates to a normalized level, and not
an attempt to slow the growth rate of the economy.
While a declining interest rate market has resulted in
strong performance from bonds, low absolute levels of interest actually
significantly reduce the potential for future returns. One of the primary goals of a zero
interest rate policy is to reduce the cost of financing for companies. Companies have been able to issue bonds
to investors at all-time low interest rates. While this is a good deal for companies, it’s not a great
outcome for investors, who are forced to take increasingly lower compensation
for the risk of lending this money.
The yield on the Barclays U.S. Aggregate Index was just 2.3% as of September
30th, compared to 6.6% twenty years ago. Low coupon rates generally mean poor opportunities for
returns and more recent results have reflected that as the Barclays Agg has
returned just 1.7% in the last three years.
While an increase in interest rates will likely result in negative
returns for bonds in the near-term, it greatly improves the long-term return
potential by allowing investors to reinvest coupons at higher interest rates.
In our estimation, investors in the Barclays U.S. Aggregate Bond Index might
experience a drawdown of as much as 7.5% if interest rates were to rise by 2%,
but would still be expected to achieve a 10-year annualized return 0.7% higher
than a scenario in which interest rates remained unchanged and no drawdown
occurred2. This
scenario analysis highlights both the importance of protecting against the
near-term risks of an interest rate increase but also the improvements to
long-term total return opportunities.
Low interest rates
can cause investors to take on more risk:
Sustained low interest rates also have significant impacts
on investor behavior, which can cause imbalances in the capital markets. Low interest rates means the retiring
baby boomer generation in particular are not able to depend on the same level
of income from their municipal bonds portfolios. Due to the lack of income in
bonds, these investors have been forced to buy areas of the equity market that
pay dividends, such as the utilities sector, but may expose themselves to more
risk than is appropriate as a result. Increases in interest rates will bring
increases in income from bond portfolios, and allow investors with lower risk
profiles to return to more suitable asset allocations.
Pension funds will also benefit from a rising rate
environment. These funds are
required to report an estimate of the value of their future obligations to pay
benefits to retirees. Since the
bulk of these payments will occur in the future, they use a “discount rate” to
calculate the value of the future payments in present terms. This discount rate is tied to the
prevailing interest rates in the market. Lower interest rates means a lower
discount rate, which results in larger future obligations. As interest rates fall, the pension
fund’s financial health deteriorates and they are also forced to adopt a more
aggressive or risky asset allocation to achieve the returns needed to pay
retirees. Conversely, if interest
rates rise, pension funds should regain healthier financial conditions, the
risk levels of their investments can be reduced, and payments to the
beneficiaries will ultimately be more secure.
Active management
will benefit:
Sustained low interest rates have also presented challenges
to the performance of active managers through the encouragement of irrational
investor behavior and unsustainable low financing costs. While influencing the equity markets is not
a stated goal of the Federal Reserve, it is an outcome of their zero interest
rate policy. As described
previously, low income and poor total return expectations in bonds have pushed
fixed income investors into buying stocks in the utilities sector. In 2014, as interest rates fell, this
sector returned 29%, outpacing every other sector in the market. Active managers were broadly underweight
the sector on fundamental concerns that high relative valuations and
chronically low growth rates posed significantly greater risk than the promise
of 3-4% of income. In this
environment, active managers posted one of the worst years of relative
performance on record.
In addition to changing investor behavior, low interest
rates offer greater support to companies in poor financial condition making it
more difficult to separate good investments from bad ones. Low interest rates mean low financing
costs for companies raising money through the issuance of bonds. This low cost financing benefits
companies in poor financial condition or those that have been mismanaged
disproportionately to high quality, well-run business. The best-run companies are typically
rewarded with low financing costs in all market environments, or in many cases
do not need to rely on debt financing at all because they are able to fund new
projects and investment from cash flow from their existing business. A decrease in interest rates has little
effect on the cost structure of these companies.
Conversely, when interest
rates are low, low quality companies that need to raise cash from the debt
markets are able to do so at lower costs than ever before. The stocks of these low quality
companies can be rewarded in low interest rate environments as their
fundamentals appear improved, but as interest rates rise and the costs of
financing increase, these results will be unsustainable. While the style of active managers can
vary, most look to buy companies with superior business models and strong management
teams, which should benefit on a relative basis as interest rates rise leading
to active manager outperformance.
Conclusion:
Given the attention the media gives the topic it is easy to
get caught up in the intense debate of when the Fed might raise interest rates,
but as recent history has shown it is difficult to predict. In the beginning of 2014, 46 economists
polled by the Wall Street Journal expected the Federal Funds rate to be an
average of 1% by the end of 2015 and yet today the effective rate remains
roughly 0.1%. At Federal Street
Advisors, we believe the game of attempting to time an unpredictable interest
rate rise is not one that our clients will benefit from playing. While we recognize that there are
near-term risks to bond portfolios associated with an interest rate increase,
it is increasingly important to keep the big picture in mind: a higher interest
rate environment is both inevitable and healthy for the market, and investors
who are well prepared will benefit.
Director, Equity and Fixed Income Research
5 Years Experience As the Director of Equity and Fixed Income Research, Alex is responsible for identifying and evaluating long-only equity and fixed income managers. His primary responsibility is monitoring client investments and making sure our fund managers' performance is in line with our expectations. He also evaluates potential new managers.
Alex earned his Bachelor's degree in Economics from Colgate University. Alex is a CFA charterholder, holds the CAIA designation, and is a member of the Boston Security Analysts Society.
1 "Historical Changes of the Target Federal
Funds and Discount Rates."
Federal Reserve Bank of New York, n.d. Web. 30 Oct. 2015. http://www.newyorkfed.org/markets/statistics/dlyrates/fedrate.html
2 Analysis assumes a parallel shift in the yield
curve occurring evenly over the first 12 months with income being reinvested at
higher rates. Full scenario analysis is available upon request.
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