Fixed Income: Inflated Expectations

Head of Fixed Income Strategy
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If there has been any lesson to be learned in the fixed income arena since election day, it is that, yes, interest rates can go up. There seems to be little doubt fixed income investors had become increasingly accustomed to the opposite scenario in 2016. In fact, a question which came up regularly in conversation was: How much lower can the U.S. Treasury (UST) 10-Year yield go? Given recent developments, the exact opposite question is now being asked.
When examining fixed income strategies for 2017, it is important to put the recent run-up in UST yields in perspective. In our opinion, the post-election movement has brought UST yields to levels comparable to what was registered roughly a year ago. If you were Rip Van Winkle and had fallen asleep in November 2015, only to just reawake, you’d probably be wondering what all the fuss is about. For those of us who were not in a deep slumber over the last 12 months, we have witnessed firsthand the volatility in Treasury yields in 2016 and now can’t help but wonder: Where are we going from here?
U.S. Treasury

At current yield levels, the UST market has essentially “priced out” recessionary and deflation/disinflation fears and has also removed the flight-to-quality bid. However, the positive impact on economic growth from potential fiscal stimulus and any attendant increase in inflation expectations are not currently being reflected. In addition, a more hawkish Federal Reserve (Fed) rate hike cycle for next year is also not part of the current pricing mechanism in Treasuries. That leaves investors in a wait-and-see mode for now, but one could argue that the base case for 2017 is that we will likely see some form of fiscal stimulus and regulatory relief.
Elevated inflation expectations and actual inflation data will be watched more closely by the money and bond markets moving forward. The turnaround in energy prices from the lows witnessed earlier this year should result in higher overall readings in the months ahead, while the recent upward trend in wages will also need to be monitored. Against this backdrop, the “breakeven inflation rate,” or the difference between the yield on a nominal bond (such as the U.S. Treasury 10-Year note) and an inflation-linked, or real yield bond with the same maturity (such as the 10-Year U.S. Treasury Inflation-Protected Securities or TIPS), will serve as a useful guide regarding inflation expectations. As of this writing, this rate has widened to 1.92%, a visible increase from the 1.20% low printed in February and the highest reading since summer of last year. However, this reading is still below the 2.04% five-year mean and well below the peak of 2.66% during that period (see graph).
With the fixed income landscape being altered post-election, investors should examine their portfolios to ensure they are prepared for a potential volatile environment for the remainder of this year and into 2017. If fiscal stimulus, regulatory relief and additional Fed rate hikes are your base case for 2017, you should consider an approach to help mitigate potential interest rate risk. The WisdomTree Barclays U.S. Aggregate Bond Zero Duration Fund (AGZD) and the WisdomTree BofA Merrill Lynch High Yield Bond Zero Duration Fund (HYZD) are two vehicles investors can utilize to help achieve this goal. These Funds can be used as a complement to a core fixed income strategy or as stand-alones for this approach.
Unless otherwise noted, data source is Bloomberg, as of 11/22/2016.

Important Risks Related to this Article

There are risks associated with investing, including possible loss of principal. Fixed income investments are subject to interest rate risk; their value will normally decline as interest rates rise.  The Fund seeks to mitigate interest rate risk by taking short positions in U.S. Treasuries, but there is no guarantee this will be achieved. Derivative investments can be volatile and these investments may be less liquid than other securities, and more sensitive to the effects of varied economic conditions.  
Fixed income investments are also subject to credit risk, the risk that the issuer of a bond will fail to pay interest and principal in a timely manner, or that negative perceptions of the issuer’s ability to make such payments will cause the price of that bond to decline. The Fund may engage in “short sale” transactions of U.S. Treasuries where losses may be exaggerated, potentially losing more money than the actual cost of the investment and the third party to the short sale may fail to honor its contract terms, causing a loss to the Fund.  While the Fund attempts to limit credit and counterparty exposure, the value of an investment in the Fund may change quickly and without warning in response to issuer or counterparty defaults and changes in the credit ratings of the Fund’s portfolio investments.  Investing in mortgage- and asset-backed securities involves interest rate, credit, valuation, extension and liquidity risks and the risk that payments on the underlying assets are delayed, prepaid, subordinated or defaulted on. Due to the investment strategy of certain Fund’s they may make higher capital gain distributions than other ETFs.  Please read the Fund’s prospectus for specific details regarding the Fund’s risk profile.

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About the Contributor
Head of Fixed Income Strategy
Follow Kevin Flanagan
As part of WisdomTree’s Investment Strategy group, Kevin serves as Head of Fixed Income Strategy. In this role, he contributes to the asset allocation team, writes fixed income-related content and travels with the sales team, conducting client-facing meetings and providing expertise on WisdomTree’s existing and future bond ETFs. In addition, Kevin works closely with the fixed income team. Prior to joining WisdomTree, Kevin spent 30 years at Morgan Stanley, where he was most recently a Managing Director. He was responsible for tactical and strategic recommendations and created asset allocation models for fixed income securities. He was a contributor to the Morgan Stanley Wealth Management Global Investment Committee, primary author of Morgan Stanley Wealth Management’s monthly and weekly fixed income publications, and collaborated with the firm’s Research and Consulting Group Divisions to build ETF and fund manager asset allocation models. Kevin has an MBA from Pace University’s Lubin Graduate School of Business, and a B.S in Finance from Fairfield University.