The Federal Reserve has spoken. Interest rates will remain just a tick above the all-time lows. And signs point to just two to three interest rate hikes in 2017. But investors using the federal funds rate as a gauge for bond market action are looking in the wrong place. Instead, they should be focused on several other fixed-income trends that should alarm you. Ignore them at your peril.
Former Vice President Dick Cheney said in 2002 that "deficits don't matter." That was when the U.S. carried $6.3 trillion of debt on its books. That figure now exceeds $18 trillion, and it's bound to start rising at a quickening pace.
The Congressional Budget Office predicted in late January that we'll add another $10 trillion to our debt burden in the next 10 years. And that doesn't even account for the potential impact of proposed tax cuts and infrastructure spending that the Trump administration aims to pursue.
Until now, a key reason why we've ignored this issue is that the government's interest expense is quite low. The U.S., state and local governments spent $432.7 billion in interest coverage in fiscal 2016. Roughly speaking an increase in interest rates of 1 percentage point, which appears to be the projected path in the next 12-18 months, adds another $190 billion to that sum.
For the record, we spend $264 billion on the Departments of Education, Health & Human Services, Veterans and Housing, combined. So $190 billion more each year is not an insignificant sum. Rising government borrowing will soon start to crowd out other lenders, pushing up rates regardless of the Fed's actions.
It gets worse. The Fed is about to compound the problem. When the Fed moves rates up to 1.00%, likely later this year, it has also signaled that it will start to unwind the massive $4.45 trillion in assets parked on its balance sheet, eventually back to the $1 trillion level where it stood before quantitative-easing programs began. How the bond market will handle all that supply coming back into the market is anybody's guess.
Simply put, not only is the era of ultra-low interest rates coming to an end, but it could end very badly. That's what the bond vigilantes taught us back in the 1990's.
That's why this is a good time to revisit your fixed-income exposure. Most investors aged 50 and older have a little or a lot of bond exposure, and bonds and bond funds that are exposed to longer duration (i.e., five years or more) could see bond values fall even more than the paltry yields they offer.
The best form of inoculation against rising bond prices is to own bond funds that adjust their yields in tandem with interest rates, as they'll hold almost all their value in a bond rout.
A great approach is with senior bank loan funds, which focus on variable-rate debt to high-quality issuers. Default rates are very low, they see little price movement, and their payouts adjust to prevailing changes in interest rates with a 30-90 day lag. These loans are typically secured by collateral such as equipment, real estate or accounts receivable.
The PowerShares Senior Loan ETF (BKLN - Get Report) is a very popular choice, with $8.6 billion in assets under management. Yet the 0.65% annual expense ratio seems a bit high. That expense bite will be less of a concern, of course, when yields start to rise to higher levels. The SEC yield stands at 2.8%.
The Highland/iBoxx Senior Loan ETF (SNLN - Get Report) , which has $500 million in assets under management, carries a slightly lower 0.55% expense ratio, even though both funds have almost identical three-year return rates of around 1.95%, according to Morningstar. Its 3.9% yield is also more impressive.
Investors can also choose from a pair of actively managed senior loan funds, the Credit Suisse Floating Rate High Income (CHIAX - Get Report) fund and the First Trust Senior Loan ETF (FTSL - Get Report) . These funds could prove to be more adept at avoiding the isolated troublesome loans that would pop up in a recession. But thus far, they have not yet outperformed to an extent that would justify their expense ratios, which approach 1.0%.
Investors are taking a "let it ride" approach to their bond funds, as it has now been smooth sailing for many years. But the stars are aligning for a potentially destructive era for fixed- income investments. It won't be an event that plays out suddenly, but like a frog in a pot of water that's been put on a hot burner, we may only realize how dangerous this asset class was in hindsight.
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