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Why the Fed rate hikes haven't increased your return...yet
Sunday 30, September 2018

Why the Fed rate hikes haven’t increased your return….yet

Marian Ross 2

Interest rates in the U.S. are rising. However, chances are, the interest rate on your USD investment account has not increased. In fact, it may even have gone down.  Today we look at why higher interest rates in the U.S have not led to a broad increase in fixed income investment yields. This analysis applies primarily to yields on short term money market accounts as well as medium term fixed income investments such as bonds. The robust economic growth in the U.S. and the improving global economy, has resulted in a reduction in risk with a commensurate fall in  yields on many new securities. In some parts of the market, a reduction in supply of new issues has also been blamed for the persistently low yields being observed.

 

This past week, the U.S. Federal Reserve increased its benchmark interest rate for the third time this year and signaled its intention to hike once more in 2018 and 3 times in 2019.  What effect have rising short term U.S. interest rates had on the market?

 

Short term U.S. Treasury yields have risen significantly. The yield on the 2-year and 5-year US Treasury securities have risen by roughly 92 bps and 73 bps respectively year to date. The 2 year is currently yielding 2.81% and the 5 year is currently yielding 2.94% (Versus 1.88% and 2.21% respectively at the end of 2017). In contrast, long term yields have not risen to the same extent. The yield on the 10 year and 30-year U.S. Treasury has risen by 63 bps and 43 bps respectively year to date. The 10 year is currently yielding 3.04% and the 30 year is currently yielding 3.17%. These are still very low yields by historical standards.

 

Why is this important?  We use US Treasuries as a benchmark for pricing many types of fixed income securities. The yield of many fixed income securities is calculated by adding a margin to the yield on the U.S. Treasury.  For example, in April 2018, Netflix issued a 10-year bond at a spread of 291 basis points (or 2.91%) to the 10-year US Treasury. The 2.91% is referred to as the “spread” and the 10-year Treasury is the “benchmark”. At the time, the 10-year Treasury was yielding approximately 2.9752%. When one adds the spread of 2.91%, the total yield on the bond at issue was around 5.8852%.  The spread plus the benchmark represents the yield / return on the investment.

 

As the Fed increases rates, the benchmark increases.   However, even though the benchmarks are rising, the spreads - which determine how much “extra return” you get above the benchmark - are not rising. In fact, spreads are declining in certain parts of the fixed income market. This trend has emerged in the second half of the calendar year. The impact of the rising benchmark is being partially offset by declining spreads.

 

Why are spreads are declining? A spread is positively correlated to the risk of the issuing entity. The higher the risk, the higher the spread (above the benchmark) investors must be paid. Because the global economy is growing, the “credit profile” of companies and Governments is improving, i.e. they are becoming less risky and healthier. With a better credit profile, you can issue debt at lower spreads, thereby producing lower overall yields.  

 

Some analysts have also highlighted that there is less supply (of new securities) in certain parts of the market, particularly “high yield” securities (i.e. riskier assets).  Less supply results in more money chasing the same securities (bidding up the price and down the yield).

 

 

 

What are the implications for your investment strategy?   

More risk for more return: To get a higher yield you must take higher risk. If you ask your investment company to offer you a higher rate on your investment, it will have to offer you riskier assets. In your search for yield, get a clear understanding of the downside risk and what your protection is.

 

Stay short: As you will see from the analysis above, there is very little “extra yield” offered by taking a bond that has a longer maturity date. (5-year UST yield of 2.9% vs. 10 UST year yield of 3.04%) For this reason, it is very important for investors to stick to bonds with shorter call or maturity dates. This allows investors to obtain better risk adjusted returns in the short term and reinvest with better terms when interest rates are higher.

 

Marian Ross is an Assistant Vice President of Trading & Investment at Sterling Asset Management. Sterling provides financial advice and instruments in U.S. dollars and other hard currencies to the corporate, individual and institutional investor. Visit our website at www.sterling.com.jm Feedback:  If you wish to have Sterling address your investment questions in upcoming articles, e-mail us at: info@sterlingasset.net.jm

 

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