I’ve discussed on The Blog how an investor can think of the federal funds rate and QE as a gas pedal. Sometimes it’s good to ease off a bit to limit the pace of acceleration, as a way of more smoothly getting the economy up to long term growth rates. We still don’t expect the Fed to hit the brakes and push the fed funds rate above the “longer run policy rate”; instead we expect continued declining acceleration. The gradual decrease in mortgage and Treasury bond purchases is the beginning of this reduced acceleration, as we believe the Fed aims to end its bond buying program before gradually increasing the fed funds rate.
My colleague Rick Rieder notes that the new policy outlook provides some unique opportunities for investors, specifically:
Long-end municipals in the U.S.: Munis took a considerable hit a year ago when interest rates rose sharply, but have gained momentum in the past two quarters as interest rates have declined and sentiment has improved; we believe there is value to be found here as a source of income in a continued yield challenge environment.
Market Realist – The graph above shows how short-term municipal bonds, represented by the iShares Short Term Munis ETF (SUB), remained relatively steady despite the movements in interest rates. Short-term munis offer stabler income, though at a lower yield. The longer-term munis, as represented by the iShares Muni ETF (MUB), offer a higher yield given their longer-term nature. But they’re much more sensitive to swings in interest rates.
Mortgage-backed securities (MBS): The housing sector continues to improve, and while its recovery has slowed recently, we believe the upward trend will continue. The continued low level of market volatility is also good for MBS performance.
Market Realist – The seasonally adjusted Case-Shiller Index shows that the housing market has staged a strong recovery and momentum remains strong. The low mortgage rates, aided by the Fed’s open market purchases of mortgage securities, have allowed the housing sector to recover. As investors start pricing in increases in mortgage rates, driven by the increased expectations for the Fed funds rate, credit lending will become more expensive and the housing market will slow down. Given the extended horizon for an increase in interest rates, it seems plausible that the housing market will continue to recover in the short to medium term.
Rieder warns that one place to be cautious is the short-end of the U.S. Treasury curve (two to five years); we believe valuations are still distorted by current Fed policy.
Sources: Federal Open Market Committee, June 18, 2014
Fixed income risks include interest-rate and credit risk. Typically, when interest rates rise, there is a corresponding decline in bond values. Credit risk refers to the possibility that the bond issuer will not be able to make principal and interest payments.
There may be less information on the financial condition of municipal issuers than for public corporations. The market for municipal bonds may be less liquid than for taxable bonds. Some investors may be subject to federal or state income taxes or the Alternative Minimum Tax (AMT). Capital gains distributions, if any, are taxable.
Mortgage-backed securities (“MBS”) and commercial mortgage-backed securities (“CMBS”) are subject to prepayment and extension risk and therefore react differently to changes in interest rates than other bonds. Small movements in interest rates may quickly and significantly reduce the value of certain mortgage-backed securities.