A Revised Timeline for Rate Increases, Should We Be Worried?
By: Heather Rupp, CFA, Director of Research for Peritus Asset Management, the sub-advisor to the AdvisorShares Peritus High Yield ETF (HYLD)
Last week we heard the results of the latest Fed meeting. To little surprise, they continued with the “tapering” of $10 billion a month. However, the clarity Yellen offered as to likely finishing up the latest round of quantitative easing by the fall of this year and then start looking to raise rates about 6 months after that, seemed to catch everyone momentarily off guard.1 All of a sudden the market is worried that rates may be going up a few months earlier than had previously been expected. In a knee jerk reaction, we saw Treasury yields spike and equities take a hit. Yet on the flip side, the Fed did revise language that tied rate rising to a 6.5% jobless rate target, abandoning this link and giving them a bit more flexibility in waiting to increase rates, as the current jobless rate now nears that 6.5% level.1
So what does this mean for us as high yield investors? Very little. In the scheme of things, what does it really matter if the fed funds rate starts rising in mid-2015 versus late-2015/early-2016? From our perspective, do those few months at all change our investment strategy? No. Our investment objective will remain focused on generating what we view as high current income, with the potential for capital gains, over the long term. Yes we do consider the interest rate environment and outlook, but at the end of the day, our focus is on yield and value as we make our investment decisions. Furthermore, as we have profiled before, high yield bonds have historically had a negative correlation to Treasury rates2, and have actually performed well during periods of rising rates3 (see our piece “Strategies for Investing in a Rising Rate Environment”).
The other thing to consider is that markets are forward looking. The reality is that if rates are expected to increase, the markets will react well ahead of that. For instance, last summer when the first rumblings of the “tapering” happened, the markets swiftly reacted and Treasury rates saw a significant move in the latter half of the year. And as we entered 2014, the consensus was certainly that rates would be rising, but so far, even with last week’s move, rates are below where we ended 2013. For instance, the 10-year Treasury is at a yield of 2.78% (as of 3/20/14) versus ending 2013 right around 3.0%. So have markets largely already reacted to the expectation of higher rates? Maybe so. This move in Treasury rates that we have seen since last summer is well ahead of any 2015 actual increase in the fed funds rate, and ultimately if that increase happens in June 2015 versus December 2015 would seem to be irrelevant.
So yes, markets are manic and hypersensitive to Fed-speak in the immediate. But in the longer term, we don’t see the specific timing as something to be laser focused upon. Investors instead need to analyze and determine how to broadly be positioned in this environment. As we have recently written about, we actually see a number of factors, among them the muddling global economy, demographics, and liability driven investing, that could actually help constrain rates as we go forward (see our piece, “Of Elephants and Rates”), and so far we have seen constrained rates in the first quarter of 2014. The reality is that we see value in the high yield market and attractive yield to be had for those that can actively pick and choose securities in that market, irrespective of whether rates rise or not.
1 Federal Reserve, 3/19/14 meeting statement and press conference.
2 Acciavatti, Peter, Tony Linares, Nelson R. Jantzen, CFA, Rahul Sharma, and Chuanxin Li. “2013 High Yield-Annual Review,” J.P. Morgan North American High Yield Research, December 23, 2013, p. 112, 97.
3 Back up data sourced from JP Morgan and the Federal Reserve. Peritus Asset Management, “Strategies for Investing in a Rising Rate Environment,” http://www.peritusasset.com/wp-content/uploads/2014/01/Strategies-for-Higher-Rates-Final.pdf, p. 4-5 for annual details.