Fixed Income Outlook: How Will Rates Affect the Bond Market?

12.10.2018 - Jeffrey S. MacDonald, CFA


The Fed's March Toward Neutral Reduces the Risk of Negative Returns

The Fed has raised rates eight times in the past three years, inching closer to a normalized level of interest rates that aims to encourage full employment and keep inflation in check. Although that precise target remains uncertain, it seems clear that the Fed is moving beyond monetary policy conditions that it considers accommodative and into an environment where it expects less tightening to be required.

It’s too early to start celebrating, but this is encouraging news for fixed income investors. Each rate hike brings us closer to the end of the current tightening cycle, and as we approach a pause in tightening the risk of higher rates delivering negative returns to fixed income investors is reduced. Also, unlike earlier in this cycle, the ability to earn more income through higher rates can provide investors with a buffer against interest rate-related price declines in the event rates continue to drift higher as we expect.

Munis: Stronger demand, tighter supply

The municipal bond market appears well positioned for the environment ahead, with solid demand for munis expected at a time when supply continues to be constrained.

As rates rise, we expect the tax-advantaged income municipal bonds offer to continue to be attractive to investors in high tax brackets. At the same time, the new tax code could reduce supply in two ways: First, federal income tax deductions for state and local tax payments are now capped at $10,000. So local taxpayers could become less inclined to approve new bond issuances, which tend to raise property taxes. Second, the new tax code prohibits the issuance of any more pre-refunded munis, further constricting market supply. In our view, this combination of weak supply and strong demand should support muni prices and reward investors next year.

Within the muni market, our outlook is most favorable for high-quality revenue bonds as we expect the tailwind of a strong US economy to support the fees and taxes that service the payment of the debt from those issuers. Our view of general obligation bonds has improved slightly as the strong US economy has supported tax collections at the state and local level, but the overhang of unfunded pension liabilities is likely to continue to challenge some issuers in this sector going forward.

Corporate Bonds: Focusing on Credit Quality

In broad terms, we expect the climate to be favorable for corporate bonds next year. Tax reform should put downward pressure on issuance as we expect overseas cash repatriation and solid earnings to reduce the need for companies to borrow. Also, as part of the new tax plan, the deductibility of interest against corporate earnings has been capped, making it less tax-efficient for companies to leverage up their balance sheets.

Within the corporate bond market, we continue to retain a positive outlook for investment-grade credit, which should benefit from continued economic growth and strong corporate fundamentals.

Volatility late in the year has increased investor concerns regarding leverage on corporate balance sheets. While we acknowledge and share these concerns for specific issuers, we believe the broader corporate bond market still maintains a solid ability to refinance and service its debt.

For below-investment-grade issuers, we have seen isolated examples of deteriorating underwriting standards against a backdrop of strong demand. While the additional income offered by high yield may continue to be attractive to investors, we remain cautious regarding underwriting quality and investor risk appetite for high yield bonds in 2019.

This analysis is provided for illustration and discussion purposes only and does not guarantee future results. Please speak to your Fiduciary Trust contact if you have questions or would like more information. This communication is intended solely to provide general information. The information and opinions stated are as of December 1, 2018, and may change without notice. The information and opinions do not represent a complete analysis of every material fact. Statements of fact have been obtained from sources deemed reliable, but no representation is made as to their completeness or accuracy. The opinions expressed are not intended as individual investment, tax or estate planning advice or as a recommendation of any particular security, strategy or investment product. Please consult your personal advisor to determine whether this information may be appropriate for you. This information is provided solely for insight into our general management philosophy and process. Historical performance does not guarantee future results and results may differ over future time periods.

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