Regardless of whether the next rate hike occurs in September or December, the market and the Fed agree that the increase in the Fed’s policy rate will be slow and steady. Looking beyond 2016, however, is where markets are still drastically underpricing the Fed’s stated course. The Fed’s median projection for the long-term (approximately five years) fed funds rate is 3%, but the market is currently pricing in a mere 1.65%.
Value Remains Elusive
Another strong rally in lower-quality bonds has resulted in richer valuations across the fixed income market, making value difficult to find [Figure 3].
We still believe in fixed income for its diversification benefits as a risk mitigation tool, but no fixed income sector stands out as overly attractive. We continue to view investment-grade corporates as potentially delivering incremental value over Treasuries, and think mortgage-backed securities (MBS) may add value as a high-quality option against a backdrop of range-bound yields. Although we believe high-yield may be slightly overvalued at this point, given its tremendous strength year to date, we still think a small allocation can add value for suitable investors, given its substantial yield. We prefer municipals over Treasuries, as a favorable supply/demand imbalance should remain a tailwind, with state and municipal spending still restrained, and the market’s appetite for yield remaining insatiable.
Anthony Valeri is fixed-income and investment strategist for LPL Financial.