Investing In Bond ETFs As Rates Rise

September 26, 2018

Josh JenkinsJosh Jenkins is senior portfolio manager and co-director of research for CLS Investments. He is the portfolio manager of two conservative allocation mutual funds of ETFs, a money market fund, and a series of multi-asset income-focused separately managed accounts, which also use ETFs. recently spoke with Jenkins to discuss the latest developments in the fixed-income markets, including where rates are headed and how investors should position themselves in the current environment. The Fed is poised to hike rates this week and perhaps again in December. How many more hikes do you see the Fed making this cycle? Is there a terminal rate it’s aiming for before it stops hiking?

Josh Jenkins: We look at the dots that they publish with their expectations. What they see as the terminal rate is the best guidepost for our view. Right now, the Fed is projecting the midterm or long-term rate as between 2.75% and 3%. Four more hikes would get us there.

The market is expecting two more hikes this year, one in September and one in December. That’s consistent with what we expect.
The Fed is actually pointing to three hikes for 2019. Our view would probably be a little bit less than that, maybe two hikes, which is a little bit more in line with the market. Before the financial crisis, rates topped out around 5%. Why do you think the ceiling for rates is lower this time around?

Jenkins: There’s been a lot of discussion around demographics being a challenge, but I’d say a lot of it boils down to the fact that the recovery has been very slow. That’s kept a lid on long-term rates, at least for the time being. We’ve seen a much bigger move higher in yields on shorter maturities than longer maturities this year, which has translated into a flattening of the yield curve. Is that something you expect that will continue?

Jenkins: To us, that is one of the biggest, most important questions. The yield-curve inversion has been essentially a perfect indicator of recessions over the last 50-60 years. It would seem unwise to aggressively hike and intentionally invert the curve.

We’re concerned about that. I don’t think it’s lost its predictive power. We believe the short end is going to continue to move up. The question is, what’s going to happen to the long end? Are our growth and inflation expectations going to pick up and continue to boost the long end? Or are we going to see the inversion?

We’re not trying to make that call. We’re in a wait-and-see approach, and we’re trying to prepare portfolios regardless of what happens. How should investors position themselves in this current environment, where it seems like short-term yields are going to continue to move up, but the trajectory of long-term yields is more uncertain?

Jenkins: Out view relates to a long-term investor. Our view is that, regardless of what's happening to long-term interest rates, you want high-quality duration in your portfolio to offset equity risk.
Historically, there’s been a negative correlation between stocks and bonds. We think that holds today. As rates creep up, you might have, in the near term, some small losses in your bond portfolio. But that’s dwarfed by the potential loss that could manifest itself in an equity portfolio.

The stock market is pretty richly priced. We’re not calling for a recession, but we think, this late in the cycle, one could definitely happen. We’re more concerned with balancing risk in an entire portfolio than being focused specifically within the bond portfolio.

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