Since the election we have had a fairly dramatic move in rates. Both the five-year and 10-year U.S. Treasury bonds rose more than 30 basis points in less than a week, which is an astonishing move in such a short period of time. We have also seen a sharp rise in inflation expectations.
Why have we seen such a dramatic rise in interest rates?
The Trump economic plan calls for increased fiscal spending, reduced regulation, a significant change to rules governing financial-services institutions, a potential change of leadership at the Fed and increased trade protectionism. If President-elect Trump is able to push these policies through, it could be very bullish for the economy while also inviting unexpected inflation and triggering faster interest rate hikes from the Federal Reserve.
Higher inflation obviously eats into the value of future cash flows of nominal bonds, so in response investors demand a higher yield to compensate them for this risk. The risk of higher inflation has been one of the main drivers behind the selloff in U.S. Treasury bonds, as evidenced by the jump in break-even inflation rates. The potential specter of faster Federal Reserve tightening is another big driver of the selloff because investors again are demanding a higher yield now that they anticipate interest rates rising more quickly in the future.
Should we make any changes to our fixed income strategy?
The emphatic answer is no. Interest rate risk, reinvestment risk and credit risk are the three biggest risk factors when investing in fixed income. By buying high-credit quality bonds, we greatly reduce credit risk, leaving only interest rate and reinvestment risk. What we are currently seeing in the markets is interest rate risk, which is the possibility that, as rates increase, bonds of longer maturities will go down in value. Reinvestment risk, on the other hand, is the risk we had been seeing over the past several years. This occurs when a security matures and the prevailing interest rate is lower than when the security was originally purchased. Unfortunately, interest rate and reinvestment risk are at loggerheads. If you try to eliminate interest rate risk by buying only very short maturities, you are introducing more reinvestment risk and vice versa.
Our approach of building short- to intermediate-term ladders balances these two risks. For example, over the past several years as rates have fallen steadily, the longer rungs of the ladder have appreciated greatly. This has offset the fact that maturing bonds were being reinvested at lower yields. Now, the opposite is happening. As rates have risen, the longer rungs of the ladder have dropped in value, but they can now be offset by reinvesting maturing bond proceeds at higher yields. By staying in short- to intermediate-term maturities, we have also significantly reduced our interest rate risk compared to longer term portfolios and with only small sacrifices in yield.
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