The Election Impact on the High Yield Market: Rates and Regulation, The Interest Rate Outlook
By Heather Rupp, CFA, Director of Communications and Research Analyst for Peritus Asset Management, Sub-Advisor of the AdvisorShares Peritus High Yield ETF (NYSE Arca: HYLD)
With the recent Trump victory, we are seeing a move upward in rates due to the expectation that the Trump/Republican initiatives, including infrastructure spending and other fiscal stimulus, will drive economic growth and the idea that with a Republican controlled House and Senate, tax cuts are very likely to get passed, and those tax cuts in turn could cause demand-pull inflation. While we would view his stronger job market and economic growth scenario as a positive for credit fundamentals and the high yield market, potential inflationary pressures could mean that the Fed is more aggressive in increasing rates than we would have expected a month ago, and we see the various securities on the Treasury yield curve are reflecting this possibility. The Federal Reserve directly controls the Federal Funds Rate, an intra-bank lending rate with their interest rate changes. However, expectations of their movements and market forces impact US Treasury rates, which were 1.83% on the 10-year the day before the election and now have crossed 2.3%—a 50bps move. Will rates keep moving up? We wouldn’t expect a dramatic move upward from where we are now.
There are a few important factors to consider. First, no matter who the president is or how much stimulus is applied, it doesn’t change global demographics. We have an aging population domestically and worldwide. As people age, their investment focus tends to shift from the capital appreciation expected from equities and instead favors income generation and capital preservation—which fixed income securities can provide. With this demographic reality, pension plans are likely to concentrate more on matching assets and liabilities, again which the fixed income market provides. Pension plans and retail investors alike are huge participants in the financial markets and we’d expect that given the demographic shifts, these aging buyers will be shifting out of equities into fixed income over time. Additionally, the aging population will also have an impact on global demand, in turn impacting the need for the Fed to be aggressive with rate increases. Spending on everything other than healthcare tends to decline with age, which can serve to stall the growth story. For more on this reality, see our pieces “Zero Sum Game” and “Of Elephants and Rates.”
Another consideration is the yields on our medium and longer term debt versus sovereign debt rates globally. How much can US rates dislocate from the rest of the world? 10-year bonds in much of the rest of the world are yielding around 0-1% and many of these economies are still in the midst of quantitative easing and stimulus. So comparatively, with our higher rates and better economic conditions, we believe this keeps buyers in our market. The dollar will certainly be a consideration for investors—but the dollar will be a consideration for the Fed as well as they look at how aggressive to be with rates.
Also keep in mind that higher rates can become self-fulling; in essence higher rates thwart growth and a need for rates to keep increasing. A key point of monetary policy is to manage economic growth as the Fed works to fulfill their mandate of keeping inflation in line. As growth declines, lower rates can be used to stimulate growth, and vice versa, as growth increases, higher rates can be used to choke off whatever growth there is.
The economic growth, lower taxes, and increasing inflation scenario, and higher rates along with it, are certainly not foregone conclusions. While the Republicans control Congress, it is only by a narrow margin in the Senate, so there may be some negotiation and moderation that may have to happen as they look to make a change to individual and corporate taxes. Additionally these “stimulus” efforts will take time and it may well be a balance of positive growth from that versus a potential negative impact if some of the potential protectionist measures discussed during the campaign come to light and impact our global trade/exports. And between the higher rates our Treasury bonds already offer relative to the rest of the world, in addition to the demographic reality, we believe this will serve to sustain demand for US Treasury bonds, constraining rates on those from increasing too far. It is the 5 and 10-year rates that matter the most for us as high yield investors.
While we have so far seen a notable step up in Treasury bond yields, and if some of this proposed economic stimulus pans out and some inflation along with it, we may see rates rise further. But we still believe there will be a solid global demand for the US Treasury bonds given our rates relative to the rest of the world and the global demographics, both of which we believe will constrain our rates from a big move upward. While we believe the high yield market is positioned well among the fixed income alternatives should rates rise (see our piece “Strategies for Investing in a Rising Rate Environment” and “High Yield in a Rising Rate Environment”), we also believe this market is well positioned should our expectation for rates to still face headwinds in moving up play out. Time and time again over the last few years, we have seen rates move up, only to quickly retrench, and those sitting on the sidelines out of fear have missed the yield and return potential this market has to offer.