Should You Be Changing tactics with the Fed?
- The market now expects no rate hikes in the U.S. in 2019
- This is a marked shift in sentiment from 2018 when investors flocked into ultrashort fixed income assets due to fears about rising interest rates
- As the Federal Reserve is no longer in a firm rate-hiking cycle, the investment thesis for investing in ultra-short funds has weakened
A change in rhetoric from the Federal Reserve (Fed) has called into question a popular asset allocation call of 2018, which saw over $70bn flow into the Morningstar Ultrashort Bond category1, says Insight Investment’s Gautam Khanna.
In 2018 the overarching market view was that the Fed would continue its rate-hiking cycle well into 2019, based on underlying economic strength and relatively hawkish language from Fed Chairman Jerome Powell and co.
As a result, many investors chose to reduce duration in their portfolios by moving into ultrashort assets – a common approach in a rising interest rate environment.
In our view, the thesis behind this allocation is now in question.
The Fed dot plot now shows zero hikes in 20192, while the futures market is fully pricing in a rate cut in 20203.
As such, fixed income decisions taken last year, warrant a rethink, in our opinion.
OVERNIGHT INDEXED SWAP
The overnight index swap denotes an interest rate swap involving the overnight rate being exchanged for a fixed interest rate. An overnight index swap uses an overnight rate index such as the federal funds rate as the underlying rate for the floating leg, while the fixed leg would be set at a rate agreed on by both parties.
What do investors want from fixed income?
In reviewing fixed income allocations, we think it is important investors remember two of the primary reasons behind investing in the asset class; namely, diversification from equity risk and income generation.
Even in a rising rate environment, the income component paid out by intermediate-term bonds helps mitigate the price impact from rising yields. Generally speaking, bonds with longer durations have a higher yield (risk free rate plus credit spread) and therefore generate a higher degree of income. This is reflected in the outperformance of intermediate-term fixed income category versus ultra-short fixed income on a total return basis over the past 15 years. (See Figure 2.)
A risk-adjusted measure of returns calculated by using standard deviation and excess return to determine reward per unit of risk. The higher the Sharpe Ratio, the better the fund’s historical risk-adjusted performance.
A measure of historical downside risk, calculated as the average of yearly maximum drawdown measures calculated over a three-year period using monthly data.
Additionally, over the same time period, intermediate-term fixed income has delivered greater diversification benefit from equity volatility compared with ultra-short fixed income, particularly in down markets.
It is not our base case that we are heading towards an imminent recession and/or a Fed rate cut. But, we believe the U.S. economy is slowing to around trend growth, which over the past decade is growth of around 1.9% per year.4
However, if the Fed shifts towards policy easing in the not too distant future then having duration exposure in fixed income allocations could provide an important source of ballast against potential equity market volatility. (See figure 3.)
A statistic that measures the degree to which two variables move in relation to each other. A negative number shows two assets have historically moved in the opposite direction, while a positive number shows they have historically moved in the same direction at the same time.
There may be a number of reasons investors moved into ultra-short duration products last year. But if it was to shelter from rising interest rates – a thesis that is no longer valid – then we believe now is the time to revisit that trade.
1 Source: Morningstar as of December 31, 2018
2 Source: Bloomberg as of March 20, 2019
3 Source: Bloomberg as of March 27, 2019
4 Source: Trading Economics as of December 31, 2018
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