The markets yawned when the Federal Open Market Committee raised its target by 25 basis points for the federal funds rate on Dec. 16, since the widely anticipated move had already been priced into the market. When the Third Avenue Focused Credit Fund halted redemptions from its high-yield fund in early December, there was much consternation but no contagion into other junk bond vehicles.
In a November interview, Kathy Jones, chief fixed income strategist for the Schwab Center for Financial Research, pointed out that the markets had already priced in the Fed rate hike. "Look at two-year notes," she said, "they're yielding almost 90 bps; a year ago they were yielding 22, 23, so clearly the market has discounted a couple of rate hikes at the short end."
However, the pace of further Fed increases in 2016 and the prospects for more volatility, especially in the currency markets, along with more quantitative easing by the European Central Bank and its counterparts in Japan and China, may well affect yields next year.
As for the Fed itself, in a Dec. 22 note to investors, George Rusnak, co-head of global fixed income strategy for Wells Fargo Advisors, pointed out that in its Dec. 16 statement, the Fed "included the word 'gradual' twice when referring to the path and probability of future rate hikes. The addition of this word indicates that the Fed will be quite cautious before making future rate increases."
Just as the Fed communicated regularly before taking action on Dec. 16, Rusnak believes the Fed "will work to clearly guide the markets prior to rate hikes in order to avoid market disruptions."
Below, we look at the outlook for some specific fixed income sectors. As for the bigger picture for bonds, Timothy Paulson, fixed income investment strategist for Lord Abbett, said in a note to investors on Dec. 21 that the consensus in 2016 is for rising interest rates and a flattening yield curve, in which rates on shorter-maturity issues rise faster than those of longer maturity.
Despite that consensus, Paulson reminded investors that "markets move when expectations change, and those expectations could be volatile as we get more information on economic data" throughout the year. Paulson also reports that Lord Abbett has already seen "some increase in risk premium in asset classes like high yield, emerging-market bonds, and leveraged loans, where yield spreads widened meaningfully in 2015."
Wells Fargo's Rusnak said he expects the Fed to raise rates "only two to three times in 2016" and thinks it "very unlikely that the Fed will consider going back down to a zero interest rate policy (ZIRP) anytime soon."
Jones said Schwab's view on how fixed income investors should react to higher rates "is that if we're going to see a flatter yield curve and higher volatility, then we're cautious on credit — we're neutral on high yield, we're underweight EM bonds and international developed market bonds because we think the dollar will continue to go up."
So what does Jones like? "We're looking at the upper tranches of the credit quality spectrum," she said.
Moreover, she suggested that investors might want to use a barbell strategy, where you have some short-term paper — CDs, cash — that will adjust as short-term rates move up and add to the bond portfolio "some high-quality intermediate term bonds to generate the income" that clients need.
