Pulse Points > May Investments & Market Update:
Gill Capital Partners May 2018 Commentary
What are we talking about at Gill Capital Partners?
Our Investment Committee meets weekly to review portfolio allocations, macro-economic events and our investment managers. Below are some areas that are top of mind within the committee.
Rising Interest Rates
Over the last nine months, interest rates have been pushing methodically higher across the maturity curve. Yields on 10- & 30-year U.S. Treasury bonds recently hit the highest levels since 2011, briefly reaching 3.1% and 3.25% respectively, and now have settled back to levels of 2.85% and 3.03%. Interest rates are moving higher on the back of strengthening economic fundamentals, anticipation of higher inflation, and the continuation of the Federal Reserve balance sheet unwind. The economic strength in the U.S. is broad-based and becoming more difficult to discount. Corporate earnings continued to deliver very strong results in the first-quarter. With about 70% of companies in the S&P 500 Index having reported, almost 80% have reported positive first-quarter earnings surprises, which is the highest since 2009. On the inflation front, historically tight labor markets combined with higher commodity prices are stoking inflationary fears. What does the prospect of higher interest rates mean for your investment portfolio, and do we need to do anything to prepare?
People have been calling for and preparing for higher interest rates for about as long as we can remember, but interest rates have been reluctant to cooperate. Bond yields have been moving lower since the early 1980’s, when yields on the 10-year U.S. Treasury peaked out at nearly 16%. Home owners during that period might remember mortgage rates near 20%. We are certainly a far cry from those levels. In fact, we are still well below the long-term averages on interest rates. However, it has been a long time since investors have seen a rising interest rate environment, and different considerations are certainly warranted. While predicting the direction of interest rates is a fool’s errand, there appear to be mounting risks that rates will continue to move higher, and particularly on the long end of the interest rate curve (10+ years), where we have seen less movement. It is exposure to the long end of the curve where we are particularly cautious in the current environment. Long dated bonds are more sensitive to changes in interest rates. For example, a 1.00% (100 basis point) move higher in the 30-year U.S. Treasury yield would equate roughly to a 17% loss in market value of the investment. In this hypothetical case, the investor will still receive the par value of the bond upon maturity, but the interim volatility can be alarming, particularly at current low interest rate levels. This experience is certainly not one that most investors sign up for when they are investing in bonds, and all things being equal we would prefer to avoid such an experience.
To be clear, we are not forecasting a rapid rise in rates; truthfully, nobody knows exactly what interest rates will do. However, we see very limited upside in having exposure to highly rate-sensitive investments, and potentially significant downside. Therefore, our Investment Committee has been thoughtfully modifying our fixed income allocations to target specific maturities on the short end of the interest rate curve, where yields are significantly higher than they were a year ago, and reducing exposure, whether it’s direct or within mutual funds, to longer dated maturities. We continue to have a strong preference for individual fixed income or defined maturity securities over bond mutual funds. We recently sold two funds we’ve held for a long period of time because we are no longer comfortable with their exposure to the long end of the curve, especially in a mutual fund structure.
We discuss interest rates and the yield curve weekly and will keep you informed if and when there are changes to our outlook.
As always, please let us know if you have any question or concerns, or if we can provide assistance with any other financial planning matters including education, taxes, insurance or estate needs.