Go Tactical, Consider Active With Bonds

What to make of the current interest rate environment, and how to navigate it as a fixed-income investor are questions the upcoming Inside Fixed Income & Dividend Investing Summit will attempt to answer. Taking place Nov. 13-14 in Newport Beach, California, the conference will bring together advisors, investors and market experts, including Christian Menegatti, chief investment strategist at Windhaven Investment Management, a division of Charles Schwab Investment Advisory. Here, Menegatti offers us a preview into his perspective on the fixed-income landscape, and what it means for investors.

ETF.com: Fed Chair Powell recently said we're far from a neutral policy rate. What's your general view on the interest rate outlook?

Christian Menegatti: Every time we think about an outlook, it's to be taken with a huge fistful of salt. Measures like “neutral” or Fed fund rates a year from now tend to be goal posts that move as data and policy change.

The outlook, as we see it today, tends to be more about explaining the current environment than knowing what's going to happen in the future. And I think that being good at recognizing the current environment can get you a long way in investing, especially if you’re a tactical investor.

That said, there’s a simple way to think about the Fed funds rate. If we look at the dot plot, the Fed is telling us that the Fed fund rate will peak around 3.5% and then it will probably have to come down a little bit. Generally, “neutral” is a little bit before that peak; so, somewhere between 3-3.5%.

The market doesn't share that view. Fed fund futures are projecting a peak for the Fed Funds rate in 2019 at about 3%. If you go by that, then “neutral” would be a little bit lower than that, maybe somewhere between 2.5-3%. The truth about “neutral,” then, is somewhere between, say, 2.8% and 3.3%.

But even without an exact forecast of where neutral is, thinking about where it could be allows us to construct a timeline that’s relevant for markets. If we assume neutral is somewhere between 3-3.5%, and today we’re at 2.25%, that means we have roughly four hikes to get to neutral. At the current pace, we'll get to neutral at some point toward the end of next year or early 2020.

ETF.com: What happens once we hit neutral?

Menegatti: It’s another assumption, but neutral means the Fed will hike a couple more times to get to restrictive conditions, which would put the peak for Fed fund rate at some point in the first half of 2020.

Now, the market sees through that. That means the market knows that when you get to peak Fed funds rate, you're at the end of the cycle, and a recession follows at some point in the next couple of quarters. So, the market starts pulling back before the recession happens. That’s why a broad timeline for rates is useful to investors.

ETF.com: Do we need higher rates? Can't we stay low for longer if things are going well?

Menegatti: I'm sure the Fed is asking itself that question every day. That's why the pace of hikes is a big assumption. Probably the Fed will be able to get another four rate hikes next year. At the same time, there might be big turns for the worse in data, or maybe all of a sudden inflation picks up. That’s why forecasting is difficult.

Right now, just observing the current environment—unemployment at a four-decade low and inflation hovering around 2%—we’re not too hot, not too cold either, with growth averaging over 3% in the first two quarters. There’s room for the Fed to raise rates.

I don't know how much more, but the December hike would appear to be a given. I wouldn't be surprised if they started raising rates in March again. Again, all of this is subject to a lot of things, but right now, yes, they should raise interest rates.

ETF.com: As a tactical investor, are you making portfolio adjustments in your fixed-income side? How are you investing for this?

Menegatti: Without making forecasts, we've thought over the past couple years that the economy was in good shape, and therefore, slowly or quickly, rates would have been moving up. So, we thought the way to be positioned in fixed income was to be short duration compared to whichever benchmark you’re using, and long credit.

That’s worked very well, because the economy has continued to be in good shape. High-yield credit has also been relatively stable, and we felt we were getting paid for the risk we were taking, and maybe still are.

We believe taking shorter duration and credit exposure has been the way to deal with this rising interest rate environment while the economy remained strong.

ETF.com: We’ve recently seen a pickup in outflows from high-yield bond ETFs. You still find them attractive as rates rise?

Menegatti: As we continue into the cycle, to your point earlier, the Fed could slow down and decide that they keep the rates lower for long and hike much more slowly. That, combined with some of the fiscal stimulus that has been put in place, keeps this economy going for longer without having a recession maybe in the next two or three years. That’s a plausible scenario.

What we've seen in the market recently has been a short-term reaction to a very quick-moving rate that essentially not only hurt whoever has taken duration exposure, but it creates concern around the timeline of the Fed.

Because the spike in rates fuels the perception of a slightly more hawkish Fed, that would essentially compress the timeline we talked about before. If that's the case, investors start taking off risk, and high yield is no exception. If one believes that we'll fall into recession in the second half of next year, then, yes, one may want to start reducing exposure to risky assets in general.

This is a personal view, and not necessarily the way we'll be positioned three months from now. I still don't think we’ll fall into a recession before 2020, and at present, sell-offs in high yield at a 3.5% spread could be a buying opportunity—that said, bear markets could show up in absence of recessionary conditions in the economy.

ETF.com: At the conference, your panel tries to answer the question: What to do if you need to earn 5% or more today? What's your main message?

Menegatti: We’re still in a low-rate environment, so it depends on the constraint of the manager. The intermediate part of the Treasury curve is attractive these days. Having some high yield in a fixed-income portfolio might still be a good idea to pick up yield as the economy still appears to be fundamentally sound.

There are asset classes at this stage of the cycle—at the frontier of fixed income—that can be a good source of yield; preferred stocks are an example. They're generally issued by financial companies that currently have good balance sheets and can benefit a little longer from the rising rate environment. We don’t seem to be going toward a credit crisis like in 2008. We may see some other type of downturn, but banks’ balance sheets seem relatively sound.

In truth, earning 5% today is a high hurdle for a fixed-income portfolio. And over the next decade, it might become a hurdle even with equities. If you go back to the early ’90s, 10-year Treasury yields were in high single digits. We're not in that environment anymore. The risk-free rate is much lower, and after adjusting for inflation, you're going to have to think more creatively if you aim to achieve a 5% yield in a fixed-income portfolio.

ETF.com: In this ongoing debate about what to do about fixed income, is there anything that gets lost in the conversation?

Menegatti: Coming out of such a low-rate environment and having interest rates going up at what potentially is a late stage in the cycle can create an environment in which equities and bonds sell off in tandem.

Investors are seeing there’s no part of their portfolio that’s really holding up at times. Their financial advisers told them bonds and equities would be uncorrelated, and that would help them mitigate losses, but the recent repricing has been widespread across asset classes.

It’s crucial here to communicate with clients about these market moves. Market repricings and corrections can be normal and healthy. These days happen to take place in an environment in which bonds and equities are moving together, and that's fairly unusual.

But I’d avoid reacting to these kinds of episodes too dramatically. Don't lose faith in diversification across asset classes even if you see positive correlation between stock and bonds. Remain diversified.

Another thing I’d say is that we've come from nearly a decade where just sitting in a passive equity index was the right thing to do. I’d encourage investors to consider staying diversified, but also to consider active managers which might be able to continue to capture opportunities, but also mitigate some of the potential downside risk that’s historically part of market behavior.

One day we might look back at the decade after the 2008 recovery and label that as an environment with unusually low volatility.

Contact Cinthia Murphy at [email protected]