The Outlook for Fixed Income: Stagnant Prices, Tighter Money
The start of a new credit cycle means that income investors will have to adjust to stagnant bond prices, and new opportunities in credit markets from peer-to-peer lending will be tested by tighter monetary policy, according to David Schawel, CFA.
Returns for fixed-income investors consist of the coupon; the shortening of the bond, known as the roll; and price appreciation. Since the 1980s, falling interest rates have caused existing bonds to appreciate, as their prices increased to match the yields of bonds issued at lower interest rates. Schawel, a portfolio manager for New River Investments, thinks interest rates are nearing a lower bound.
“Most likely we’re not going to be in a 30-year bull market for interest rates falling again,” Schawel told Will Ortel during a recent Take 15 interview.
Schawel cautions fixed-income investors against assuming that bonds will continue to appreciate. Instead, the coupon and the roll will drive returns from bonds. With the roll becoming more important, investors need to pay close attention to the yield curve. Much of the return from bonds will come from the roll while the bond is on the steep part of the curve. Recently, the curve has flattened, reducing the yield premium, as the US Federal Reserve moved to tighten monetary policy.
Schawel breaks down fixed-income returns into compensation for shouldering three types of risk:
- Bondholders receive compensation for assuming credit risk. The more likely the issuer is to default, the greater the credit risk premium.
- Investors collect a premium for holding bonds with less liquid futures.
- Longer bonds pay more because there is greater risk that interest rates will rise over a more expansive time span, lowering the price of the bonds.
The challenge for fixed-income investors is to ensure that they receive adequate compensation for taking on these risks and to determine which premium offers the best value on the market.
Schawel sees the rise of marketplace or peer-to-peer lending as indicative of inefficiencies in yield. He says that institutions believe they can pick out individual loans and generate good risk-adjusted returns based on credit characteristics. Marketplace lending is appealing because it circumvents fees imposed by traditional lenders and can reach markets that banks cannot. Schawel attributes this to post-financial-crisis regulations that forced banks out of some lending businesses, creating opportunities for nonbank lenders known as shadow banks.
Lending outside the banking system, however, is largely unregulated and it is not clear how these loans are underwritten. Schawel believes these lenders will continue to grow, but may prove to be inadequately underwritten during the contractionary part of the credit cycle. As Schawel might have predicted, Lending Club’s stock dropped almost 70% over the past year as concerns about its loans and an inability to attract investors led to founder Renaud Laplanche’s firing.
“When the rubber meets the road,” Schawel said, “I think we’re going to know a lot more about these platforms and did they deliver what they promised.”
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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.
Image credit: CFA Institute
