Guido Mieth
True or false: bonds outperformed stocks in the 1970s inflation regime. As CEO Jan van Eck shared in his latest investment outlook, this is true. And it was this analysis of asset class returns in the 1970s that reinforced his conviction in the key takeaway from his outlook: buy bonds today.
Here we’ll take a look at different stages of the interest rate cycle, where we are now and how to position for the current and upcoming environment.
First Stage: Rates Begin to Rise
The first stage of a rate cycle takes place when Treasury yields are at or near cycle lows, the Federal Reserve’s (Fed’s) policy stance is maximum dovishness, and profit and economic growth is at or near a trough. The crescendo of these conditions took place in August 2020. With financial conditions supportive of inflation, growth and corporate profits, rates across the curve historically increase during this phase. During this period fixed income investors should be positioned with a maximum underweight to long duration assets.
Second Stage: Policy Normalization Takes Over
With a strong fundamental growth backdrop Fed policy moves from easy to more restrictive, which includes tapering of asset purchases and eventually hiking interest rates for the first time. Similar to the first stage, this environment is a recipe for higher rates and a higher, steeper overall yield curve.
At this stage the market also becomes concerned about the Fed’s ability to control inflation and maintain positive economic growth. Term structure volatility also starts to emerge, as pricing in a terminal fed funds rate becomes increasingly challenging. During this phase, long-end yields historically increase by more than short-end yields, known as “bear steepening.”
Third Stage: Yield Curve Inversion | We Are Here
The third stage is marked by tighter financial conditions as interest rate hikes intensify. This also starts to cool the broader economy and slow down the pace of corporate spending and profitability. The markets have entered stage three. The various cross currents of slowing growth, higher interest rates and elevated asset price volatility make capital allocation more challenging during this period. Inflation is high, growth is still positive and corporate profits remain supportive. However, earnings and economic growth have usually peaked during this period, while the Fed has committed to slowing down the broader economy. In this phase we typically experience bear flattening of the yield curve, which is marked by short term (2-year) yields being higher than longer term (10-year) yields.
Regardless of the stage, the front-end of the yield curve reflects policy rates and expectations, while longer-dated yields reflect economic growth. At this point in the interest rate cycle, future growth expectations likely matter more than current elevated inflation readings. Markets are transitioning to a new paradigm, and market volatility increases as investors adjust. Using previous periods for reference, there were several occasions in the 1970s and 1980s when interest rates fell despite elevated inflation in the 8-11% range. The common theme during those times were earnings recessions and slowing growth.
Fourth Stage: Peak Rates and Curve Steepening
The fourth stage is when the market—and, ultimately, the Fed—begins to price in and eventually cut rates. By the time this happens, economic and earnings growth is depressed and yields across the entire interest rate curve fall. During this stage, the Fed has historically cut interest rates and 2-year yields have followed lower, causing a “bull steepening” of the yield curve, as short-term yields fall faster than long-term yields.
Looking at fed funds futures and other market-based expectations, this is expected to take place in 2023. Risk is rising, and the market is starting to price in the possibility that this may take longer (potentially beyond 2024) given the Fed’s acute focus on bringing inflation back to 2%.
What This Means for Investors
We are currently in the third stage of the cycle and potentially entering the fourth stage as early as 2023, though there is a growing probability that the fourth stage arrives later. Given policy lag and the Fed’s strict focus on inflation, we believe rate cuts in 2023 are unlikely—unless something breaks in funding markets—though a pause may be possible.
For many investors with at least a five-year time horizon, we believe there is opportunity to find attractively valued bonds at current prevailing rates and capture potential future appreciation as rates peak. In particular, we believe the following investment ideas may offer ways for investors to position for the current environment and prepare for the next stage:
- VanEck Fallen Angel High Yield Bond ETF (ANGL) offers exposure to high yield bonds that were originally issued as investment grade corporate bonds. If downgrades gather momentum, keeping valuations low, this may become a strong buying opportunity in our view—particularly given the historically higher average credit quality relative to the broad high yield bond universe.1
- VanEck IG Floating Rate ETF (FLTR) provides access to corporate floating rate notes (FRNs), which pay a coupon that adjusts periodically with prevailing interest rates. FRN prices have near-zero sensitivity to interest rates, and coupons will actually increase as rates go up, making them potentially attractive in rising rate environments.
- VanEck CLO ETF (CLOI) is an actively managed ETF, sub-advised by PineBridge Investments, that provides exposure to investment-grade collateralized loan obligations. CLOs have historically offered a compelling combination of attractive yield relative to similarly rated bonds and loans, strong risk protection, and floating rate coupons that increase as rates rise.
- VanEck Moody’s Analytics® IG Corporate Bond ETF (MIG) and VanEck Moody’s Analytics® BBB Corporate Bond ETF (MBBB) offer access to attractively valued investment grade corporate bonds, while seeking to control credit risk. Tracking indices powered by Moody’s Analytics credit model, the strategies target bonds that provide a higher credit spread than their modelled fair value and avoid bonds that may be at high risk of downgrade to high yield.
Disclosures
1 When comparing ICE US Fallen Angel High Yield 10% Constrained Index and ICE BofA US High Yield Index. ICE BofA rating is a proprietary composite of various rating agencies.
This is not an offer to buy or sell, or recommendation to buy or sell any of the securities mentioned herein. The information presented does not involve the rendering of personalized investment, financial, legal, or tax advice. Certain statements contained herein may constitute projections, forecasts and other forward looking statements, which do not reflect actual results, are valid as of the date of this communication and subject to change without notice. Information provided by third party sources are believed to be reliable and have not been independently verified for accuracy or completeness and cannot be guaranteed. The information herein represents the opinion of the author(s), but not necessarily those of VanEck.
An investment in the VanEck Fallen Angel High Yield Bond ETF (ANGL) may be subject to risk which includes, among others, high yield securities, foreign securities, foreign currency, credit, interest rate, restricted securities, market, operational, call, energy sector, consumer discretionary sector, information technology sector, financials sector, index tracking, authorized participant concentration, no guarantee of active trading market, trading issues, passive management, fund shares trading, premium/discount and liquidity of fund shares, non-diversified, and concentration risks, all of which may adversely affect the Fund.
An investment in the VanEck IG Floating Rate ETF (FLTR) may be subject to risk which includes, among others, foreign securities, foreign currency, credit, interest rate, floating rate, floating rate LIBOR, restricted securities, financials sector, market, operational, sampling, index tracking, authorized participant concentration, no guarantee of active trading market, trading issues, passive management, fund shares trading, premium/discount and liquidity of fund shares, non-diversified, and concentration risks, all of which may adversely affect the Fund.
An investment in the VanEck CLO ETF (CLOI) may be subject to risks which include, among others, Collateralized Loan Obligations (CLO), debt securities, LIBOR Replacement, foreign currency, foreign securities, investment focus, newly-issued securities, extended settlement, affiliated fund, management, derivatives, cash transactions, market, Sub-Adviser, operational, authorized participant concentration, new fund, absence of prior active market, trading issues, fund shares trading, premium/discount, liquidity of fund shares, non-diversified, and seed investor risks. The Fund may also be subject to liquidity, interest rate, floating rate obligations, credit, call, extension, high yield securities, income, valuation, privately-issued securities, covenant lite loans, default of the underlying asset and CLO manager risks, all of which may adversely affect the Fund.
An investment in the VanEck Moody’s Analytics® IG Corporate Bond ETF (MIG) may be subject to risks which include, among others, investing in European issuers, foreign securities, credit, interest rate, liquidity, restricted securities, information technology sector, consumer staples sector, financials sector, energy sector, market, operational, call, sampling, index tracking, authorized participant concentration, no guarantee of active trading market, trading issues, passive management, data, non-diversified, concentration, fund shares trading, premium/discount and liquidity of fund shares risks, all of which may adversely affect the Fund. The Fund’s assets may be concentrated in a particular sector and may be subject to more risk than investments in a diverse group of sectors.
An investment in the VanEck Moody’s Analytics BBB Corporate Bond ETF (MBBB) may be subject to risks which include, among others, investing in European issuers, foreign securities, BBB-rated bond, credit, interest rate, liquidity, restricted securities, consumer discretionary sector, information technology sector, financials sector, market, operational, call, sampling, index tracking, authorized participant concentration, no guarantee of active trading market, trading issues, passive management, data, non-diversified, concentration, fund shares trading, premium/discount and liquidity of fund shares risks, all of which may adversely affect the fund. The Fund’s assets may be concentrated in a particular sector and may be subject to more risk than investments in a diverse group of sectors.
Investing involves substantial risk and high volatility, including possible loss of principal. Bonds and bond funds will decrease in value as interest rates rise. An investor should consider the investment objective, risks, charges and expenses of the Fund carefully before investing. To obtain a prospectus and summary prospectus, which contains this and other information, call 800.826.2333 or visit vaneck.com. Please read the prospectus and summary prospectus carefully before investing.
© 2022 Van Eck Securities Corporation, Distributor, a wholly owned subsidiary of Van Eck Associates Corporation.
Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.
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