Watching interest rates is similar to monitoring Iceland’s volcanoes. After years of staying low, it’s inevitable they will flare up but difficult to accurately predict when and to what extent. Just as observers were attuned to recent alerts about the possible eruption and disruption of the rumbling Bardarbunga volcano, investors have been preparing this year for rising rates amid expectations of stronger economic activity.

Higher rates have yet to surface. At the start of 2014, the Wall Street consensus pegged yields on 10-year Treasury notes, then around 3%, to hit 3.44% by year’s end. Instead, 10-year Treasury yields slid in mid-August to a 14-month low of 2.34% and kicked off October at 2.42%.

“I always say that when everyone’s on one side of the ship, that’s when the ship is not going in the right direction,” says Mark MacQueen, co-founder and managing director of Sage Advisory Services Ltd. Co., an Austin, Texas-based registered investment advisory firm with $10.7 billion of assets under management. Approximately $9 billion of this is invested in fixed income.

“The market surprises this year for multiple reasons,” he says. The U.S. economy got off to a very weak start because of severe winter weather. Offshore investors have engaged in the tremendous buying of U.S. Treasurys, which offer yield advantages over debt issued by many Asian and European countries. There is also a smaller supply of Treasurys to purchase because the Federal Reserve has continued to buy them and because the U.S. budget deficit has recently shrunk significantly.

“It all kind of mixed into not a seller’s market but a buyer’s market,” he says.

During a recent annual Federal Reserve conference, the central bank’s chairwoman, Janet Yellen, said the Fed expects to complete its asset purchases program by October 2014 but hinted that it wants to see the labor market strengthen before raising rates. Many economists now expect a Fed rate increase—the first one since 2008—in mid-2015.

Sage anticipates that higher economic growth and inflation could push 10-year Treasury yields to the 2.5%-3% range by year’s end. This is barring a surprise such as a major stock correction or an outside event like the acceleration of a war or continued unrest in the Middle East or Ukraine, says MacQueen. He expects U.S. economic growth to get back on pace to 2.5% to 3%, noting that 2.5% may be more logical.

Spreads between Treasurys and corporate bonds are also likely to stay very tight for some time, he says, noting that tight spreads have made it tougher to make money for clients. To help cope with this challenge, Sage has been seeking out corporate issuers who have been in some kind of trouble that creates widening spreads.

“We’ve taken advantage of some of those situations, thinking that when they widened out they were more attractive,” he says. One example is BNP Paribas SA. In July, the U.S. Department of Justice slapped the French banking giant with an $8.97 billion fine for its transactions with parties subject to U.S. sanctions.

MacQueen cautions that some corporate credits are already fully priced with the tighter spreads. So when it comes to investing, “It’s more name-specific than it used to be, and you really have to do your homework on everything now.”

 Currently, Sage’s fixed-income allocations are 45% in corporate bonds, 22% in government and agency debentures, 12% in “AAA”-rated asset-backed securities (credit card and automobile loan receivables), 10% in commercial mortgage-backed securities, 8% in agency mortgage-backed securities and 3% in cash.

This year, the firm has slightly reduced its exposure to corporate bonds while increasing exposure to mortgage-backed securities. In agency mortgage-based securities, it is buying 3.5% and 4% coupon issues. “New production of these are a fraction of what the market anticipated, so they can outperform,” says MacQueen.

Sage continues to move out of higher beta names and into lower beta names—those with lower volatility than the market as a whole—because when corporate spreads do widen, the firm wants to have less spread risk, he says. Its fixed-income portfolio is overweight in the financial, utility and transportation sectors.

Within its government allocation, Sage has added some Treasury inflation-protected securities (TIPS) to hedge against the expected modest inflation. The company thinks the Fed may start tightening interest rates, at the earliest, in late 2015 to help curb inflation.

High-yield bonds are not held in Sage’s traditional accounts but are currently part of its core-plus allocation. Sage approaches the high-yield market through exchange-traded funds. Earlier this year, it swapped the longer-duration iShares iBoxx $ High Yield Corporate Bond ETF (ticker: HYG) for the shorter-duration Pimco 0-5 Year High Yield Corporate Bond ETF (HYS) to try to lower interest rate risk.

In general, the duration on Sage’s fixed-income portfolio runs 10% to 20% short of its benchmarks’, says MacQueen. That has hurt its performance this year, he says, but will be a benefit when rates rise.

All of Sage’s clients have some allocation to fixed income. “I say to my clients, ‘I can’t just decide I’m not going to be in the bond market because there’s nowhere else to be, and it is your safety net,’” he says.

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