Milwaukee, January 29, 2016 – After several years of unprecedented stimulus and a zero interest rate policy, the Fed in December began the process of normalizing interest rates with a .25% increase. Following is a conversation with Baird Advisor Senior Portfolio Manager Warren Pierson discussing how Baird is adjusting to the Fed's actions and offering advice to bond investors for 2016.
Did you realign your portfolios in anticipation of the Fed's widely signaled rate hike?
We haven't made any significant adjustments in the weeks leading up to the Fed's anticipated rate increase. Over the last couple of years, we gradually positioned the portfolio to benefit from a flattening of the yield curve and to be more defensive in response to a higher macro risk environment. Our duration neutral approach keeps our portfolios tied to the durations of their respective benchmarks, and we don't try to predict the direction of interest rates. But we do make adjustments to our portfolios' sector and yield curve positioning over time.
We do not view the Federal Reserve's current policy as tightening, but rather relaxing policy to a more normal interest rate posture. In late 2008 and early 2009, the Fed was in "emergency mode" and their zero interest rate and quantitative easing policies were completely appropriate in the midst of the worst crisis in decades. But it is hard to argue that we are still in that same crisis mode, and the Fed needs to normalize rates.
We are clearly in a time like no other. While pundits analyze past cycles, we think it may be very different this time. Case in point, when has the Federal Reserve raised interest rates when broad commodity prices are hitting new lows and still falling?
We don't expect the Fed to move quickly to normalize rates, but the markets could still move quickly in anticipation of the Fed or in reaction to other news.
2016 started with some harsh global news in China and elsewhere. Does this keep you up at night?
Uncertainty and geo-political pressures seem to be a constant. It means that the markets often always focus first on what could go wrong.
The Fed has been very accommodative, and a lot of money has flowed into bonds over the last few years. We pay close attention to liquidity and believe that investors got a glimpse of trouble in the high yield market in late 2015 when a mutual fund, facing significant redemptions, closed its doors. It was a reminder to all investors to be sure you are comfortable with the level of risk you are taking. We think investors should be very cautious about sectors that are intrinsically less liquid like high yield or bank loans.
Market liquidity is still satisfactory at this time, but if outflows from the bond market increase, it would be a concern. We are also watching whether rising interest rates scare investors or attract additional interest. We maybe at an inflection point where some investors with increased exposure to higher risk areas of the market may realize they aren't as comfortable and cut back on exposure.
Another area with potential liquidity issues is ETFs. While ETFs offer daily liquidity, prices adjust with selling pressure, and that liquidity could come at a steep price. We saw a little bit of that late in the year. As the Fed tightened and yield spreads widened, investors bought fewer ETF shares and several ETFs traded below their intrinsic value.
How are you positioned for 2016?
We remain focused on investment grade, US dollar denominated bonds. We continue to favor corporate bonds. Fundamentals remain good; we see solid corporate balance sheets and earnings. While earnings growth has slowed, most companies are making money and have adequate cash to make interest payments on their debt. The supply of corporate bonds has remained high, yet demand has not kept up causing spreads to widen.
Even though we see value in some sectors of the bond market, we remain constantly vigilant and focused on risk. When we look at the bond market right now, we are more cautious and thinking about what could lead to trouble; we aren't banging the table about opportunities at this time.
In this environment, we try to seek a yield advantage. We pay close attention to roll down and use floaters – securities that should adjust and not fall in value when rates rise. We are underweight to mortgage pass through securities as these bonds could extend and underperform.
We are overweight to financials – if rates rise, it should take earnings pressure off banks. At the margin, a rise in rates helps their earnings.
We believe many investors – individuals and institutions alike – may have higher risk exposure than may be appropriate. The Fed's exceptionally accommodative policy has led to a "risk on" mentality for many investors. But it is probably not a time to take on a lot of risk.
How can investors take a more defensive posture in the face of rising rates?
In late 2015 and early 2016, volatility has clearly increased. While we generally encourage investors to follow a disciplined long-term plan and not to react to short-term volatility, we do see very good value in short and intermediate maturities. This is because they have higher visibility on credit fundamentals and generally lower volatility.
In an election year, are you at all worried about proposals that might change the rules?
The bond market is huge and we would like to believe that one candidate could not derail it. But there is a lot of uncertainty due to unconventional candidates who are showing early leads. Again, another reason for investors to be cautious.
Do investors need to adjust expectations?
The longer we are in a slow-growth, lower rate environment, the harder it is for people to meet their return expectations. In a 2-3% rate environment, you can't expect 7 to 8% returns on investment grade bonds. Investors need to scale expectations accordingly.
Top line growth is hard to come by and will be a challenge for many corporations. As bond holders, we aren't as concerned about slow growth. This is harder for equity investors as companies struggle to grow earnings.
Baird is an employee-owned, international wealth management, capital markets, private equity and asset management firm with offices in the United States, Europe and Asia. Established in 1919, Baird has more than 3,200 associates serving the needs of individual, corporate, institutional and municipal clients. Baird has $152 billion in client assets. Committed to being a great place to work, Baird ranked No. 5 on FORTUNE's 100 Best Companies to Work For in 2015 – its 12th consecutive year on the list. Baird's principal operating subsidiaries are Robert W. Baird & Co. in the United States and Robert W. Baird Group Ltd. in Europe. Baird also has an operating subsidiary in Asia supporting Baird's investment banking and private equity operations. For more information, please visit Baird's Web site at www.rwbaird.com.
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