A Deeper Dive – The Impact of Rising Interest Rates | 1st Quarter 2018
In a Nut Shell: Investors tend to closely follow movements in the stock market, but over the past two quarters we’ve witnessed some interesting developments in bonds as yields have moved higher. While there is no certainty that rates may have finally begun the long-anticipated climb higher, there is one notable difference distinguishing this most recent move from others that fizzled out over the past decade. The Federal Reserve has made it clear that they are finally on a path to “normalizing” rates after nearly a decade of easy monetary policy.
The change in policy and rates has understandably prompted questions and concerns from clients about what exactly this means for markets and portfolios. As with most things in the investing world some impacts are straight forward, but most are not.
For insights on our thinking regarding higher interest rates and bond yields, read below.
When investors, advisors, and the media talk about the “market” it is typically in reference to the stock market. That is perfectly understandable as that is the primary driver of portfolio returns, as well as portfolio risk. While the bond market dwarfs the equity market in terms of size (total $’s) it takes a backseat to equities in most every investing discussion. Even discussions regarding the Federal Reserve and their increases to the target interest rate often focus more on the impact to stocks than bonds. Stocks are bound to remain front and center, and for good reason, but recent movements in interest rates and bonds is deserving of increased attention.
Since the depths of the financial crisis market pundits have debated when interest rates will begin to climb and how far they may eventually go. Until recently those debates appeared to be mostly philosophical. While interest rates have had periods in which they briefly moved higher the last few years there is a notable difference with the latest increase in yields. The Federal Reserve and its “normalization” program is now in full swing, shows no signs of slowing and even some signs of speeding up. After nearly a decade of the most accommodative monetary policy in U.S. history, the Fed has raised rates 6 times (0.25% at each increase) since December of 2015. As the increases to rates has picked up speed, so has the impact to the overall bond market as can be seen in the below chart.
In the above chart we are showing U.S. Treasury bond yields for varying maturities. Moving from left to right shows shorter maturities (3 months) to longer maturities (30 year) at different points in time starting with the end of 2015. For example, following the dotted green line from left to right would tell you what yields were on 12/31/2015 for various maturities (X axis) of U.S. Treasury bonds. The additional lines show how those yields have changed with the thick black line showing where they were at the most recent quarter end. While longer maturity bond yields are still relatively unchanged, shorter maturity bonds have moved rather significantly.
What does all this mean for investors? Some impacts are more direct and certain than others, but we thought some big picture, bullet point thoughts organized into what we might consider positives and negatives would be helpful.
Let’s get the negatives out of the way first:
- Impact to Bond Prices and Returns – bond prices and returns are inversely related to interest rates or yields. As rates move higher, bond prices and returns move lower. How much the price and return of a specific bond are impacted depends on the magnitude of yield change and several bond specific characteristics (most notably time to maturity). The good news, however, is that a bond that you bought at 4% yield will still have yielded you 4% at maturity even if the bond price and return between purchase and maturity moves in the short term with interest rates.
- Discounted Cash Flow Analysis – while this is related to the first bullet as well, we’re referring to the impact on stock valuations and analysis. One valuation approach to stocks projects out all future cash flows to shareholders with the goal of discounting those cash flows back to the present and then comparing the sum of those figures with the current stock price. Higher interest rates means those future cash flows are more heavily discounted resulting in lower present value figures. This would be considered a negative as a potential stock investor, all else being equal, would require a stock price be lower before purchasing. We mention the “all else being equal” here because it rarely is (and we’ll come back to that when we get to the positives).
- Higher Cost of Capital –rates are still at historically low levels and many borrowers have locked in debt costs for the foreseeable future but the higher rates will eventually impact margins and bottom lines. This would affect new debt issuance going forward, so though the impact is directionally negative it isn’t likely to be significant in the near term.
- Competition for Capital – as bond yields remained low after the financial crisis, many investors shifted their portfolios towards equities in search of returns and yield. As bond yields become more attractive it is likely that migration will cease if not reverse. Yields are still relatively low and there is no magic reversal point, so any “migration” back to bonds is likely to be gradual.
Now for some positives (which are always more pleasant to discuss):
- Money market yields – investors that have sat on cash since the financial crisis well know that yields on cash instruments has been paltry at best. They are still nothing to get remotely excited about, but they are the most directly impacted by the rate hikes and will move higher as rates move higher.
- Future bond returns – while higher rates and yields may be a near-term negative for bond holders there is a positive, long-term aspect. Bond coupon and maturity proceeds are able to be reinvested at higher and higher yields. Again, these rates today are still relatively low, but as they move higher investors can “lock in” higher and higher returns on the portion of their portfolios in bonds.
- Economic momentum –the Federal Reserve doesn’t exactly have an unblemished forecasting track record, but they are unlikely to raise rates during periods of economic weakness. Typically, a rising rate environment indicates that they believe the economy is on solid footing and potentially accelerating. In the discussion on the Discounted Cash Flows bullet earlier we mentioned we’d come back to the “all else being equal” comment. This is where perhaps all else is NOT equal. Yes, the discounted cash flows are being calculated with higher rates (a negative), but the future cash flows themselves may need to be adjusted higher to account for stronger economic growth (a positive).
- Rising rates can coexist with rising equity markets – J.P. Morgan has a great chart in their quarterly Guide to the Markets in which they show the correlation between the direction of bond yields and stock returns. The chart indicates that while rates are still relatively low (roughly 5% or lower on the 10 Year Treasury on their chart) rates have historically moved higher along with stocks. At just under 3% currently on the 10 year treasury we are still well below that 5% figure or threshold. Higher rates does not necessarily indicate lower equities.
- Global rates remain low – not only are rates in the U.S. still low from a historical standpoint they remain low globally. In fact, while we’ve started that normalization process here most global central banks have continued their quantitative easing programs. While that dynamic exists it is unlikely U.S. rates would diverge too meaningfully from the rest of the world and the rest of the world remains very focused on improving economic growth through monetary policy which should be generally supportive of current asset values.
As someone who started his career as a credit analyst I tend to be more interested in what is happening in that world than most. Talking about interest rates and bonds, however, isn’t exactly the kind of thing that gets one invited to social gatherings! I’m still not expecting that to change anytime soon, but if the Fed and rates continue on their current path it is likely to draw increasing attention from all investors.
For more insight on what we feel the Federal Reserve’s change in policy and rates mean for markets and portfolios, please contact Brad Swinsburg 404-874-6244.
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Unless stated otherwise, any estimates or projections (including performance and risk) given in this presentation are intended to be forward-looking statements. Such estimates are subject to actual known and unknown risks, uncertainties, and other factors that could cause actual results to differ materially from those projected. The securities described within this presentation do not represent all of the securities purchased, sold or recommended for client accounts. The reader should not assume that an investment in such securities was or will be profitable. Past performance does not indicate future results.