What is IFI’s overall outlook for 2017?
Rob Waldner: We believe we are entering a new regime where growth and inflation, rather than just the actions of central banks, drive markets. We believe that President Donald Trump’s policies will be, on balance, supportive for US growth, although much uncertainty remains around policy specifics. We expect steady, although moderate, growth in Europe and China. While we are mindful of political risk globally, especially in Europe where the election calendar is heavy, we think that stronger global growth and a little higher inflation will likely determine much of the markets’ performance in 2017.
What are your thoughts on rising interest rates as you determine your asset allocation decisions? Rob Waldner: Traditionally, we think about government bonds as being a “risk-free” asset class — in other words, an asset class whose return is considered to be certain. But clearly in a world where government bond yields are very low and are expected to rise, there is little in the way of coupon income to offset downward price movement.
So for us, the idea is to invest in credit asset classes that we believe can benefit from a positive growth environment and are less correlated to government bonds. These can include investment grade bonds, high yield bonds, bank loans, emerging markets sovereign bonds and corporate bonds, as well as structured securities and even municipal bonds. In our view, a portfolio that is broadly diversified across credit sectors should be able to perform relatively well in an environment in which growth is solid.
We believe the economy is poised to perform relatively well. The thing that we need to be concerned about is the status of global financial conditions, and whether tightening financial conditions could cause volatility in credit markets in 2017. Concerns over financial conditions could arise if we see a more-aggressive-than-expected Fed, or a sharp rise in bond yields or the US dollar.
Can you describe your multi-sector approach for navigating a rising interest rate environment?
Joe Portera: In our diversified credit strategies, we seek to take advantage of different credit sectors — each one brings something a little different to the table. In the current environment of rising interest rates underpinned by growth and moderate inflation, we favor leveraged credit, such as high yield bonds and bank loans. The floating rate nature of bank loans can be especially defensive since interest rates on bank loans adjust on a regular basis to keep pace with rising short-term rates. Given these characteristics, we have increased our exposure to loans in the last couple of months.
As active investment managers, we can take advantage of bond futures to hedge portfolios and interest rate swaps to convert fixed rate holdings into floating rate holdings. If the price of the swap is attractive, we can take advantage of rising interest rates even when holding an underlying portfolio of fixed rate securities.
We also include emerging market sovereign and corporate debt as well as investment grade corporates in our diversified credit strategies. While we have de-emphasized investment grade relative to other sectors recently, given our favorable growth outlook, our analyst team can still find opportunities among these corporate bonds. Investment grade bonds bring quality to the mix in our portfolios and, despite conventional wisdom, may present select opportunities despite the rising rate environment.
What are some of your strategies for dealing with rising US interest rates within investment grade bonds, especially when valuations are so stretched?
Mike Hyman: When the bond market begins to anticipate a Fed tightening cycle, investors often react by gravitating toward the short end of the yield curve — i.e., toward shorter-maturity bonds. The general thinking is that longer-duration bonds should be avoided to potentially dodge price declines when interest rates rise. However, the shorter-maturity bonds have typically been the most vulnerable when the Fed raises rates.
That’s why in a rising rate environment, we look for opportunities in longer-term maturities in the investment grade sector to try to take advantage of attractive yields and to potentially defend against the greater interest rate increases that may occur at the shorter end.
In many of our investment grade portfolios, we are also permitted to take exposure to diversifying credit sectors such as high yield and emerging market debt. High yield can be a good diversifier for investment grade credit in a solid growth environment. Due to the higher spread of these bonds, they have the ability to absorb increasing Treasury rate movements with little change in price.
How do rising US rates affect emerging market bonds?
Mike Hyman: Rising US interest rates are generally a headwind for emerging market (EM) fixed income performance. However, emerging markets is a very diverse asset class. For example, emerging markets comprise both US dollar- and non-US dollar-denominated assets. The net exposure of EM countries to US dollar funding has declined as they have built up healthy cushions of foreign exchange reserves. Although US dollar-denominated debt, particularly corporate debt, has grown significantly in recent years, foreign exchange reserves have grown even faster.1 This may provide a buffer for most EM countries when navigating through a period of potentially higher US interest rates, particularly if funding conditions deteriorate.
As a diverse asset class, we believe EM offers enough different levers to pull to help successfully navigate the increasingly complex global financial landscape in the period ahead. Within EM, we would look for specific opportunities that stand to benefit broadly from modest global growth and more stable commodity prices.
Sources: World Bank, International Monetary Fund, Invesco. Data from March 31, 2000, to Dec. 31, 2016.
Robert B. Waldner, Jr., CFA
Chief Strategist and Head of Multi-Sector