As we turn the page on 2016, we look back on what was an unusually wild ride for fixed income markets. The year began with the price of oil declining to $26 a barrel, a level not seen in more than a decade. Given the high level of debt outstanding connected to the energy industry, more speculative corporate bonds experienced an across-the-board sell-off with energy-related high yield taking the lead. Government bonds, on the other hand, benefited from the uneasiness of investors, resulting in a decline in US Treasury rates and subsequent rise in price. Given the greater demand for government securities, yields on ten-year Treasury bonds, which began the year at 2.28%, quickly dropped to 1.67% by the first week in February. By early summer, the 10-year yield would get as low as 1.36%. Prices for bonds move opposite of yields. Fortunately, equity markets, the price of oil and speculative bonds, began to recover long before US Treasury yields bottomed out in mid-summer.
The demand for US corporate bonds gained quite a bit of momentum after the brief hiccup in January and February and has continued at a steady pace ever since. Cabot fixed income portfolios benefited from this trend as we have been positioned with an overweight to US investment grade bonds relative to the broad market indexes. Much of the demand for US bonds in general stemmed from the fact that the value of bonds with negative yields around the globe reached as high as $12 trillion. Yes that is correct, trillion! Thankfully, the Federal Reserve has not, to this point, bought into the notion of negative interest rates as a constructive monetary policy tool.
Following a rather quiet summer came the presidential election. It became quite clear in the days following the election of Donald Trump that the bond market viewed this development as an interest-rate-sensitive event. US interest rates rose with conviction immediately following the election results. Ten-year US Treasury yields increased from 1.85% up to 2.25% in the days following the election and have continued to climb since, finishing out the year at 2.45%, higher than where we began. To put this in perspective, this high-pressure selling of US Treasury bonds resulted in a price decline of approximately -6.35% for the ten-year US Treasury bond from the election through the end of 2016.
Although the rather dramatic rise in rates following the election was significant, we can’t say it was too surprising. Bond yields have a way of moving quickly in short periods of time, whether it be up or down. In this particular case, the expectation for greater spending on infrastructure projects combined with the prospect of lower taxes was interpreted by the market as bond unfriendly. Whether these policies lead to higher economic growth and higher inflation or result in a widening of the federal deficit remains to be seen. Either outcome would present a challenge for government bond yields. At this point, we are light on specific details and must not lose sight of the fact that there will also be many other factors influencing bond yields in the coming year.
We cannot stress enough the importance of precisely tracking, monitoring and adjusting the level of duration in a fixed income portfolio. Duration is a measure of a bond’s, or portfolio of bonds’ price sensitivity to changes in interest rates. We had lowered our portfolio duration when rates continually declined during the first half of 2016. By keeping our portfolio durations below the 4-year level, we were able to protect fixed income portfolios relatively well during the recent rate rise. By comparison, the ten-year US Treasury has a duration of approximately 9 years while the Barclays US Aggregate Bond Index currently has a duration of 5.85 years.
So where do we go from here? With relative yield levels on US corporate bonds compared to US Treasuries seeming to be closer to fair value, it may be a good time to rotate fixed income portfolios in a manner that raises exposure to bonds with higher credit quality. Certainly, having some exposure to US Treasuries is a bit more enticing following the post-election sell-off. As always, we will continue to take an active approach to managing fixed income portfolios. Carefully managing levels of rate exposure and credit quality are critical components to successful fixed income portfolio management.
It’s possible that we have seen the lowest level of yields we are going to see for quite a while. When we consider the fact that we are currently experiencing the second longest equity bull market in history, we are at or near full employment, consumer confidence is as high as it’s been since the financial crisis and real estate prices are back to 2007 levels in many cities, it’s prudent to keep in mind these are all characteristics reflective of a maturing economic cycle. The Federal Reserve has indicated it expects to hike the federal funds rate three times in 2017. There will be many factors influencing financial markets in the coming year, but monetary policy implications certainly will continue to be a large driver at this stage, just as they’ve been ever since the great recession. At the start of 2016, the Federal Reserve projected four rate hikes throughout the year. As they repeatedly backed off from this projection, interest rates continued to trend lower and lower. It is important to recognize similar conditions in place for 2017. We will continue to keep interest-rate sensitivity lower than the broad market bond index with the caveat that it is highly likely we’ll may experience another period of declining rates before all is said and done. High quality bonds should gain in value if this dynamic plays out. We will stick to our philosophical view that by maintaining a portfolio of higher yielding, higher interest earning securities with less interest rate sensitivity to the broad market bond index should lead to superior returns over time. However, effectively managing our duration and staying defensively positioned will be critical to achieving success within our fixed income strategy.