The Federal Reserve’s easy-money policies, more than improving macroeconomic fundamentals, are the single biggest factor behind stocks reaching record levels—and the main reason for bond yields plumbing new lows, iShares’ Head of Fixed Income Strategies Matt Tucker said.
In fact, Tucker told IndexUniverse.com’s Cinthia Murphy that massive demand for short-dated debt in the first quarter is slowly shifting toward intermediate-term fixed-income, such as the $3.76 billion iShares Barclays 3-7 Year Treasury Bond Fund (IEI), a clear sign that the long arm of the Fed isn’t going to get shorter anytime soon.
IU.com:We saw massive inflows into shorter-term bonds in the first quarter as investors looked for protection against higher rates, but is that protection worth the low yields in the space?
Tucker : If you look at the short-end part of the market, most yields are positive on a nominal basis, but if you adjust for inflation, a lot of them have negative yields on a real basis. Everyone recognizes that we are near historic lows in interest rates, and the real question is not if rates are going to rise, but when.
What we saw in the first quarter was that rates started to back up—10-year Treasurys rose above 2 percent in February—and that sparked concern among a lot of bond investors that the much-expected increase in interest rates had finally arrived.
What we saw then was a shift into shorter-duration fixed-income investments. They were willing to take on less yield, but were still able to obtain income and able to position themselves for higher rates.
IU.com:Since the end of the first quarter, we’ve seen big inflows into intermediate bonds—funds like IEI. Are investors suddenly willing to take on more risk for a little bit more yield into the curve? Is this not the time anymore to be betting on higher interest rates?
Tucker : In the first quarter, flows were dominated by shorter-duration funds, but as we’ve moved into the second quarter, we’ve seen some investors become less concerned about rising rates and be more willing to move into funds like IEI that have more rate sensitivity but that offer more yield.
We saw money come out from these Treasury funds in the first quarter—about $2 billion—and now that has all returned in the second quarter. We had some $2.5 billion come into those same funds in April and May. It reflects that investor concern about interest-rate risk has abated, so they are coming in for a little more yield.
IU.com:From a fundamentals perspective, what has changed to explain this change in sentiment?
Tucker : When I think about why rates are so low, there are three main drivers I look for. One is the state of the economy. Economic growth is fairly slow. GDP growth is low but inflation is fairly benign, so you could argue that 10-year Treasurys should be 100-150 basis points higher than they are now just based upon the economic and inflation outlook.
But you have two other major forces pushing yields down; one is continued concern about what’s happening in Europe—let’s call it global economic and geopolitical risk that’s still priced into the Treasury market—and the Treasury market is still serving as a safe haven for investors.
And finally, there’s the Fed and other central banks like China and Japan who have been buying Treasurys at healthy rates in the past couple of years, and that has pushed yields down below the levels you would expect given the current economic and inflation outlook.
Investors should pay attention to what the Fed is saying and what the Fed may do in the future. The real focus is on when the Fed might start pulling back some of the accommodation they’ve placed in the market, and the expected first place they’ll do that will be by reducing the amount of purchases they’ve been making.
They are buying right now $85 billion a month of Treasurys and mortgages, and the thought is that when that number begins to fall, that will be the first sign they’re on a path to letting rates drift higher.
But the Fed has laid out very specific targets, like unemployment targets of 6.5 percent, and we are still a full percentage point above that, so it’s unclear when we may actually see the Fed take any action.
They previously had talked about when they might remove accommodations from the market, and in the last Fed minutes, they talked about when they might add to or remove accommodations.
They’ve expanded the language in the statement to include the possibility that if they don’t think things are going well, they may actually purchase more securities in the market. That reinforces this point that we don’t have clarity as to when the Fed might act, which means we are still going to be in a low-interest-rate environment in the short and intermediate term.
IU.com:What should investors do about their fixed-income exposure right now? Do they stick with shorter-term bonds, or do they dive into longer-dated debt?
Tucker : The most important question investors have to ask is, What’s the role of fixed income in my portfolio? If they decide it’s an asset class where they want to be tactical, and they want to take on some risk to take advantage of the current environment, then they may look to shorten—or lengthen—duration based upon their outlook.
But for most investors, fixed income is seen as a stabilizer in their portfolio, a diversifier against equities and other risky assets, and most want duration in their portfolio because it’s the duration that helps offset risk associated with equities and other assets. For those investors, there’s less need to be tactical about duration for better risk-adjusted portfolio returns long term.
IU.com:Does this stock market craze where the S'P 500 and the Dow are rallying to record-highs change anything in terms of fixed-income exposure? Are you surprised by this action?
Tucker : I don’t think so. What the Fed is doing through QE is they are impacting all markets, and the prices of all markets. We talk a lot about the impact on Treasury and mortgage markets because that’s what the Fed is buying, but by pushing down yields, the Fed is essentially encouraging investors to invest in other asset classes.
What that’s done is pushed down the spread or the incremental yield an investor would get in investment-grade high-yield bonds, and it’s also pushed up equities prices. If the Fed were to step away tomorrow, you would probably see yields rise, but you would also probably see equities prices fall because those are also being supported by what the Fed is doing.
I’m not surprised by the stock market because it’s driven by the Fed and its actions. By keeping rates low, they are encouraging investors to take on more risk and put more money into riskier assets like equities.
IU.com:That run toward equities, in a way, makes your fixed-income allocation that much more important.
Tucker : Exactly. Investors have to realize that if you try to time markets and time rates, that’s a very difficult thing to do. It’s difficult for an individual investor to protect against rising rates or to make adjustments to a portfolio on a tactical basis, so they might want to go with a professionally managed fund.
Of course, the most important thing is for investors to be clear about the role of fixed income in their portfolios. If it’s a diversifier, you actually want to have duration and rate risk in your portfolio.
The curve in the Treasury space is still relatively steep, meaning you’re still getting a reasonable amount of incremental yield for extending out the curve, but you’re not getting a lot on a historical basis. The yield on 30-year Treasurys is near all-time lows. Again, if rates do rise, it’s the longest-maturity bonds that will be hit the most.
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