Yahoo Finance Investing for Income in a Reflationary World
Investors searching for income may feel like they are caught between a rock and a hard place, understandably frustrated by the low level of interest rates and expectations that the Federal Reserve will raise rates in 2017.
The Fed has signaled plans to raise rates at least twice in 2017, raising concerns about the risks of investing in longer-term bonds. President Donald Trump promises a variety of reflationary actions, including tax cuts, infrastructure spending and curbs on immigration. The potential fiscal and monetary policy changes cloud the outlook for income-oriented investments, and selectivity will be more important than ever for investors seeking income.
The economic outlook for 2017 should provide some comfort. The unexciting but steady U.S. economic recovery continued in 2016, and corporate earnings recovered from the downturn caused by the strong dollar and weak oil prices. Manufacturing indicators are strengthening, while unemployment continues to decline.
The Fed dot plot signals plans for three rate increases in 2017, though market expectations are for two rate hikes. The not-too-hot, not-too-cold nature of the economic recovery probably allows the Fed to move incrementally rather than aggressively in 2017 to normalize interest rates.
Longer-term, the three "D's" -- debt, demographics and the dollar -- may put a cap on economic momentum and limit the rise in interest rates. A fourth "D" may also limit the risk of an upward surge in rates -- perpetual demand for bonds from retirees seeking income as well as demand from insurance companies and pensions seeking to offset their liabilities. The reflationary policies favored by Trump may be watered down or delayed, moderating the impact on interest rates and inflation.
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Some income-oriented investments are more attractive than others. Given uncertainty about the pace of interest rate increases and the possibility that rates could reverse during periods of geopolitical or economic stress, a diversified and selective approach is desirable.
Government bonds. U.S. government bond yields climbed in the weeks following the presidential election, with the 10-year Treasury bond breaking through the 2.5 percent mark shortly before year-end. Rates have fallen some in recent weeks, as investors question the pace of rate hikes and the magnitude of fiscal stimulus and tax cuts in 2017. Although interest rates are considerably above their post-Brexit vote lows, intermediate and long-term government bonds are vulnerable to a further rise in rates. A slight increase in rates would erase the coupon return for intermediate and long-term government bonds. Investors concerned about potential rate hikes may want to emphasize shorter-term government bonds until there is more clarity about fiscal and monetary policy in the U.S. From a geographic perspective, some global bond investors are saying, "Buy bonds, not bunds," as German, U.K. and Japanese government bonds don't appear to offer much value relative to U.S. government bonds.
Municipal bonds. An important but often sleepy corner of the bond market, municipal bonds performed poorly in the weeks following the election. Rising interest rates were an important factor, but speculation about tax reform magnified the sell-off in municipal bonds. A reduction in the highest personal tax rate would make municipals less attractive relative to taxable bonds, as would a decrease in the tax rate for taxable bond interest. At current interest rates, municipal bonds may be appealing for income-oriented investors in higher tax brackets.
Investment-grade corporate bonds. Corporate bonds offer a bit more yield than government bonds, providing incremental income and more of a yield cushion against rising rates. However, corporate bond spreads relative to Treasurys are below average and corporate balance sheet fundamentals are deteriorating. The combination of tight spreads and deteriorating fundamentals typically isn't good for investment-grade bond returns, but strong economic momentum and low debt servicing costs are likely to prop up the valuations of investment-grade bonds in 2017.
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High yield bonds and bank loans. A strong economy boosts high yield and bank loans, and both offer meaningful yield premiums relative to government and investment-grade bonds. The yield premium offered provides more of a cushion in the event of a rate hike, though default-adjusted yield spreads are relatively tight. High yield bonds and loans are considerably more volatile than higher-quality bonds and have a higher correlation to stocks. Default rates are rising, with energy and retail borrowers among the companies facing elevated risk despite the stronger economy. Selectivity is critical in high yield and bank loans, and investors should consider actively managed strategies rather than passive exchange-traded funds.
Emerging markets bonds. Selectivity is also very important for advisors considering emerging market debt. Countries with a high proportion of U.S. dollar debt relative to GDP, such as Malaysia, Colombia and Turkey, may be vulnerable if the dollar continues to appreciate in 2017. Other emerging markets countries are benefiting from firming growth and the rebound in commodity prices and are in a better position to withstand dollar appreciation or geopolitical unrest. As with high yield and bank loans, an actively-managed approach to emerging markets bonds may be more desirable.
Bond proxies. Dividend-paying stocks offer the appeal of income and growth, though the reach for yield into growth-challenged utilities and telecommunications stocks may not pay off in 2017. In a growth-oriented environment, the market may favor dividend-growth oriented companies that can grow revenues and earnings if inflation drives interest rates higher.
Income-seeking investors face myriad challenges in 2017. Changes to the outlook for bonds and bond proxies are likely to be driven by a few key economic and geopolitical considerations, including tax and spending initiatives, trade policy, immigration changes and global geopolitical developments.
The outlook for bonds may not be as bleak as some suggest, however, as slowing population growth, the disinflationary impact of technology and the demand for income is likely to create a limit to the pace and magnitude of rate hikes.
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Investments in securities are not insured, protected or guaranteed and may result in loss of income and/or principal. This communication may include opinions and forward-looking statements. All statements other than statements of historical fact are opinions and/or forward-looking statements (including words such as believe, estimate, anticipate, may, will, should and expect). Although TFC Financial Management believes that the beliefs and expectations reflected in such forward-looking statements are reasonable, it can give no assurance that such beliefs and expectations will prove to be correct. Unless stated otherwise, any mention of specific securities or investments is for hypothetical and illustrative purposes only. The author's clients may or may not hold the securities discussed in their portfolios. The author makes no representations that any of the securities discussed have been or will be profitable.
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