The Federal Reserve announced Wednesday it would be scaling back the stimulus as the economy shows steady growth.
It's a sign things are getting better, but it also means those near-record low interest rates may start rising to help us understand what it means, what we should do and how to live on a fixed income. Fixed Income Strategist for People's United Bank Karissa McDonough explains.
Q: How did interest rates get as low as they did and why are we now facing a transition period in interest rates?
A: The current extremely low interest rate environment is a direct byproduct of the Federal Reserve trying to pull the economy out from the 2008 financial crisis, itself caused by an environment of artificially low rates and mispriced risk. The challenge that the Fed faces today is to return monetary policy to a more normal state (allow rates to rise on their own) and to do so in a manner that doesn't impair sustainable improvement in the real economy.
The degree of monetary stimulus in the global financial system remains significant. This increased liquidity has not found its way into the real economy. The concern for both investors and policymakers is that the longer it takes for this liquidity to feed through to economic growth, the greater the risk is that that liquidity could cause excess valuations in financial assets, similar to what we experienced before 2008.
Q: How is the Treasury-buying program, known as Quantitative Easing, supposed to help heal the economy?
A: The money that the Fed creates goes to bank balance sheets which then has the ability to lend that money out, leading to economic growth. However, while banks are currently in a great position to provide credit, loans are expanding only modestly. The supply of liquidity that the Federal Reserve has injected into the financial system has far outstripped the amount of new lending. There remains $2.4 trillion of cash and excess reserves on the balance sheets of American banks, eight times the pre-crisis level. The increase represents about 75 percent of the increase in the Federal Reserve's balance sheet. Household deleveraging plus tighter controls on underwriting are both serving to limit consumer lending.
If the banking system transmission mechanism is not working effectively, the only option for monetary policy to work to spur the real economy becomes the purposeful inflation of asset prices, primarily housing values, in order to spur business capital expenditures and therefore hiring.
Q: Does the current level of bond market appreciation constitute a bubble and should we be concerned about a pending correction?
A: In a broad sense, we, People's United Bank, do not believe that to be the case.
Once supportive Fed purchases of Treasuries starts to wind down, and the Fed starts to raise forward guidance on short rates, Treasury bonds at current prices have nowhere to go but down (and yields up).
Q: What are the implications for bond investors during this time of transitioning to likely higher interest rates?
A: As bond investors we need to keep in mind that the two primary goals of fixed income in an investment portfolio are preservation of principal and to mitigate the volatility of the other asset classes. Fulfilling either of these roles becomes commensurately more difficult in the face of a long term secular trend upwards in interest rates. Therefore we need to be additionally considered when constructing a bond portfolio.
Q: What do you recommend bond investors do?
A: People's United Bank recommends reducing the rate sensitivity of bond portfolios through the use of floating rate notes. Floating rate assets are a very effective hedge against rising short-term interest rates and the damage such a move would impose on the principal value of an investment portfolio. The coupons on floating rate notes reset quarterly based on a yield spread relative to high quality short-term interest rates as measured by LIBOR (or a similar index). Therefore, even if rates move significantly during a quarter, these bonds will simply reset their coupon to the same spread over the now higher index rate and the bond price moves back to par.
We continue to like assets that provide attractive income and believe that high yield bonds remain an appropriate place to invest, and a core holding in our portfolios, as long as the credit cycle remains favo rable and companies continue to be able to roll over maturing debt.
We have also recently increased our targeted weight to convertible securities, which are bonds that can be converted to stock. This way, a traditional bond investor gets the potential equity upside while still clipping a favorable coupon, essentially two layers of protection against rate-induced losses in a fixed income portfolio.