Fixed Income is Dead… Long Live Fixed Income!

Fixed income and its kin; credit, debt, yield, bonds in general and so forth make me yawn. Who cares about making 2.5% on the risk free rate if the consideration is ‘How much money can I make?’. Is 2.5% going to change the way you live, will it make you rich, or will it pay tomorrow’s bills? My kids are approaching college and that cost raises 7-8% annually. My father has been hospitalized and now in rehab… those costs and insurance premiums rise even faster. Looking for more yield means taking more risk. More risk increases the probability of permanent loss of principle.
Most bond traders make their living not from collecting yield but rather from the change in yield. Simply buying a bond when rates are high(er) and selling when they are low(er) increases the value of the bond you hold. Wash and repeat and you make money… lots of it! Since 1980’s the relatively steady decline in interest rates has been a boon for the underlying principle of all things related to fixed income.

Since mid 2016 when rates scraped 1.3% and negative overseas, washing and repeating is getting more difficult. The latest FED action and media attention raised rates. Put the reverse into action and massive losses would logically be on the horizon. Importantly, if optimism (Trump or whatever) translates into additional economic output, both GDP growth and Consumer Price Index inflation could move above the 2.0 to 2.5% baseline expectations. That would lead to higher bond yields and ultimately a more hawkish Fed. Short-to-intermediate U.S. Treasury yields are now higher than the past five years.

But, the vast range of possible outcomes in 2017 and beyond means that investors can’t rule out the possibility that the next move from the Fed could in fact be a rate cut. Smart investors observe the options market prices about a 12.5% chance that interest rates will finish 2017 lower than current levels.

What will keep US rates low (or near where they are)? The yield differential between U.S. dollar-denominated bonds and other developed markets is a major force. Foreign investors hedge their U.S. bond holdings into their home currencies. At the end of 2016, this currency-hedged yield differential between Treasuries and Japanese government bonds has been widening. Another is U.S. pension funds and others who are mandated to manage massive liabilities, they will view the recent rate move higher as an opportunity to buy fixed income. These purchases hold down the yield. And lastly the Fed has been acting on a global scale, not domestic.

Uncertainty over ‘there’ holds rates down here (China’s bubble, Brexit and the next move for the UK and EU, unsettled Middle East, and so forth).

Translation, as I explained in this article, there is a way to make money in fixed income. Additional opportunities have emerged given market misinterpretations. Standby for these ideas.