In December 2015, after seven years of near-zero short-term interest rates, the U.S. Federal Reserve (Fed) finally made good on its promise to begin the process of normalizing monetary policy by hiking the federal funds rate by 25 basis points.
It was a move the Fed had been telegraphing for months, and to call it unsurprising would be an understatement. But what happened next in many ways was surprising: For the next eight months, the Fed did nothing. As of this writing, the Fed has held five of its eight meetings slated for 2016, and in each of them has decided not to hike rates further—at least, not yet.
There have been plenty of reasons for the Fed to leave rates unchanged. Inflation has continued to come in below the Fed's 2.0% target and economic growth has been choppy: Monthly jobs gains have come in above the 200,000 mark in only six of the past twelve months. Outside the United States, the outlook is even more uncertain. Central banks around the globe are cutting interest rates and buying bonds in an effort to stimulate their economies; meanwhile, the U.K.'s June vote to leave the European Union sent shock waves of volatility through the markets and left the door open for countries to follow suit in the future.
No easy answers for fixed-income investors
Today's environment is an unusually challenging one for fixed-income investors. The Fed is anxious to further normalize monetary policy by raising short-term rates and there continues to be downward pressure on longer-term rates; case in point, the 10-year U.S. Treasury yield hit an all-time low of just 1.37% in July. The result is that government debt of any maturity—and issued by virtually any government—is some of the riskiest debt in the market today in terms of potential price volatility. Corporate debt is not without risks either; high-yield bonds have been whipsawed for the past year, trading in line with energy prices, which themselves have been volatile. While investment-grade corporate debt has arguably been a more attractive segment of the market in recent months, it too has drawbacks: All else being equal, the higher the credit quality, the more sensitive the security is to interest rates. The ideal investment in today's market, we believe, is one that offers limited credit risk, low sensitivity to changes in interest rates, and reasonable income potential. That's exactly what we're seeing today in the U.S. securitized debt markets.
A closer look at the securitized debt market
In the United States, the main sectors of the securitized debt market are asset-backed securities (ABS), residential mortgage-backed securities (RMBS), and commercial mortgage-backed securities (CMBS), each of which is composed of numerous subsectors. Securitized debt deals are typically grouped by maturity (from less than 1 year to 10+ years) and credit quality (AAA to below investment grade), which provides a relatively high degree of flexibility when it comes to portfolio construction, with ample potential relative value trading opportunities.
Another attractive feature of the securitized market is that much of the debt offers floating, rather than fixed, coupon payments. According to the Securities Industry and Financial Markets Association, the securitized debt market, excluding agency mortgage-backed securities, is approximately $4.5 trillion, and several hundred billion dollars of that is structured to have floating-rate coupons pegged to LIBOR (London Interbank Offered Rate), a broadly used benchmark for short-term interest rates. If the Fed continues to hike interest rates, the coupons on these floating-rate securities, which mostly reset monthly, will adjust higher and thus protect these securities from the price erosion of higher interest rates.
Current spreads present attractive return opportunities
In the fixed-income market, spreads measure the incremental yield various securities offer over U.S. Treasuries of comparable maturities. With floating-rate AAA spreads well above 100 basis points for many segments of the securitized market and spreads on AA-rated securities north of 200 basis points, we believe this is an opportune time to invest in high-quality, lower duration, floating-rate securitized assets.
The Fed's own projections for short-term rates call for a federal funds rate between 2.0% and 3.0% by the end of 2018. Floating-rate securities would, by definition, pay coupons at least that high, and we believe that as the U.S. economy continues to improve, future spreads on securitized debt may not be as attractive as those available today. Regardless, we believe these potential yields are extremely attractive versus the alternative of record-low yields in the U.S. Treasury market or the prospect of paying the German or Japanese government for the privilege of lending it money.