Federal Reserve chair Janet Yellen’s six-hour testimony before the House Financial Services Committee earlier this week provided confirmation that the Federal Open Market Committee (FOMC) plans to continue tapering at its current pace.
There would need to be a strong indication of change of direction in the economy for that process to stop, according to Fran Rodilosso (pictured), fixed income portfolio manager at Market Vectors ETFs.
“The once-feared tapering process is well under way and slated to continue under the new Federal Reserve chair,” says Rodilosso.
Rodilosso notes that even while a highly accommodative US monetary policy remains in place, tapering of bond purchases combined with historically low interest rates present a greater risk of rising than declining rates over the medium to long term.
“Since the tapering talk began, US high yield bond prices have generally held their value while Treasury yields have risen. US investment grade corporates, lacking the spread cushion of high yield bonds, have not held their price levels.”
While shortening duration and adding credit risk worked in 2013, with the Treasury rally in January 2014, shorter duration strategies underperformed longer duration strategies, as interest rates rose and credit spreads widened. But, one month does not make a year. Credit spreads, not just in emerging markets but in developed markets as well, moved wider. So, where is there value in fixed income?
“In an environment of uncertainty, there is value in safety,” Rodilosso says. “Keeping duration short is one important safety valve. Investment grade floating rate notes (FRNs) yield less than 1.00 per cent at the moment, and coupons will only adjust higher when short rates start rising. While this may be relatively low yield in comparison to longer-term traditional fixed rate investment grade bonds, floating rate notes have less risk of capital loss from the potential of rising interest rates. Hedging high yield bonds with US Treasuries has also been an effective way of limiting duration while isolating this credit risk.
“Diversifying is also important. With the recent correction, emerging markets opportunities exist, and I believe that emerging markets, as well as Europe, continue to be effective options for diversification across credit, currency and geography.”