So far this year, U.S. credit markets have been characterized by an unusual mixture of generally accepted expectations for things to come, followed by non-events. As a result, we have seen sporadic yet fairly minor pricing trends and adjustments. All of which is to say that it has been very undramatic—so far. Interest rate levels and the shape of the U.S. Treasury yield curve remain stable, and total returns have remained at historically lower levels. Most significantly, hovering over the credit markets is a seemingly limitless expectation (and patience) for a so-called “liftoff” of a monetary policy reversal from historically low interest rate targets to something defined only as “normalcy”. But we have seen no action as of today, and no definitive guidance yet. The long delay in adjusting policy has in fact recently become more of the dominant storyline than a possible Fed rate rise itself, freezing a confused market at yield levels that do not appear in line with either an accommodative or restrictive policy stance.
This year has also been characterized so far by an unanticipated widening of credit spreads (the difference between the yields of corporate bonds to U.S. Treasuries of the same maturities). Normally, bond investors have seen these corporate spreads tighten during periods of Federal Reserve policy turning hawkish and a rise in interest rate targets. In the past, yield spreads tightened because the Fed was reacting to a potentially overheating, strong economy. Corporate yields declined in relation to Treasuries, therefore, as businesses were enjoying an improving ability to earn profits and service debt, perhaps even reducing the need for additional bond issuance.
Credit spreads have widened this year, and appreciably so, in a stark contradiction to some expectations. Ten-year, A-rated corporate bonds, be they of Industrial, Financial or Utilities companies, have risen in yield against the 10-year Treasury by about 0.50% (50 basis points), a substantial change when spreads only ranged from 80 to 115 basis points to begin the year. Relatively, the corporate bond market has underperformed. In the third quarter, 1-10 year corporate bonds, as measured by the ML 1-10 Year U.S. Corporate Index returned 0.35%, while 1-10 year U.S. Treasury and agencies, as measured by the 1-10 Year U.S. Treasury and Agency Index, returned 1.22%. Year to date, we find similar pressure on corporate bonds in general with 1-10 year investment grade corporates underperforming 1-10 year governments at 1.42% versus 2.10%, respectively.
The third characteristic of this year’s credit market to note is the relative (and absolute) performance of the preferred securities market against other investment grade alternatives. In the third quarter, preferred securities returned 1.73%, and year to date 3.98%, as measured by the ML Fixed Rate Preferred Stock Index. Overall so far this year, preferred securities outperformed domestic investment grade and high yield bonds as well as domestic stocks.
It is clear to us that Federal Reserve Board policymakers would prefer a return to “normal” open-market operations as soon as possible. Still, we understand the complications inherent to initiating such changes and potentially “upsetting the apple cart”. Moreover, we are further empathetic to pressures on our central bank to fully consider the ramifications of a U.S. monetary policy shift on the global economy as a whole. Nobody wants to witness a policy mistake when a disruption to worldwide economic growth, and by association domestic growth, could be avoided with simple patience. We also hear the Fed’s continued call on Washington to do much more on the fiscal side of policy to simulate economic strength, rather than relying entirely on the monetary side of the public policy ledger. As such, it is as impossible as ever to accurately predict the future of interest rates.
Chairwoman Yellen has repeatedly warned that the pace of future rate increases is far more significant than the exact date the increases commence. We could not agree more. “Rate liftoff” may in fact be a misleading and unfortunate expression. Rather than denoting a spaceship heading to the moon, we think a clearer analogy given the fragile state of global economic growth may be that of the mythical Sisyphus. Just imagine setting the initial foothold behind an enormous boulder, prior to the onset of the arduous task up the mountain side. It may be a long time indeed before the edge of the boulder becomes even visible through the valley mist of economic uncertainties. It may be an eternity before the boulder reaches the top.
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