The Federal Reserve on December 14 fell in step with a post-election surge in bond yields by raising the main interest rate for the first time in a year. The Fed’s quarter-point increase followed the biggest five-week gain in the yield of the benchmark 10-year U.S. Treasury in six years.

The 10-year Treasury yield on December 12 broke through 2.5% for the first time since September 2014, pushed up by rising oil prices and expectations that President-elect Donald Trump’s goals to boost spending and cut taxes will spur economic growth and speed inflation. The selloff in bonds underscores the advantages of our strategy’s focus on bottom-up credit analysis. We have identified securities that, amid the market turbulence, are selling at more attractive valuations than before the November 8 election.

The start of a tightening cycle does not appear to be an ideal time to hold bonds, especially for the short term. Investors with a time horizon of two years or more, however, can ride out the bumps from rising interest rates and find stability and steady returns from fixed-income securities.

Indeed, during the past 20 years—a period of declining interest rates that is considered a bull market for bonds—investment-grade fixed-income securities generated a 184% return from income and just 9% from price appreciation.


Steady Updraft

Among investment-grade bonds, income generated a 184% return compared with just 9% from price appreciation during the past 20 years, a period of declining interest rates that is considered a bull market for fixed income securities.


We seek to limit the downside from any interest rate shifts and beat our benchmarks by focusing on the credit profile of individual securities and taking advantage of a mispricing of risk. By following this strategy, we have outperformed many of the investors who track macroeconomic factors in an attempt to predict the future movements of interest rates.

While not trading based on forecasts, we do see signs that interest rates will remain low for some time— well below the 4%-to-7% norm during the 1990s and early last decade. We expect that a slow, shallow increase in rates would not impair the competitive advantage we attempt to gain by focusing on credit risk and income generation.

Fed Chairwoman Janet Yellen at a news conference on December 14 bolstered the case for a scenario of slowly rising interest rates. "We continue to expect that the evolution of the economy will warrant only gradual increases in the federal funds rate over time to achieve and maintain our objectives," Yellen said after the central bank announced only its second increase in the main interest rate since 2006.

Several other factors suggest that any further tightening will be slow. Labor force participation will decline as the U.S. work force ages, hindering economic growth until 2024, according to the Bureau of Labor Statistics. Also, U.S. productivity growth has slowed for years, dampening economic vitality. Productivity declined for three quarters prior to the third quarter, when it was flat compared with a year earlier. From 1947 until 2015, productivity rose at a 2.2% average annual rate.

Moreover, the global economy remains weak, with the International Monetary Fund in October projecting 3.4% growth in 2017, only a slight improvement on its forecast for a 3.1% expansion in 2016. Inflation in the U.S., eurozone and Japan persists below central bankers’ 2% target. While the Fed is tightening, the European Central Bank (ECB) and Bank of Japan are maintaining record stimulus. The ECB announced on December 8 that it will extend its monthly purchase of bonds—known as quantitative easing—until the end of 2017.

To be sure, reflationary forces have flared since the U.S. election and pressure for higher rates may mount, further testing the nerves of bond investors. Oil prices soared to an 18-month high on December 12 after Russia and 10 other countries agreed to reduce output, following a similar announcement in November by the Organization of the Petroleum Exporting Countries (OPEC).

In the U.S., both Democrats and Republicans in Congress have backed Trump’s commitment to boost spending on infrastructure. The president-elect has also announced plans to cut taxes, prompting expectations for reflationary growth. Since the election, investors, anticipating quicker growth, have increased capital flows into the U.S., pushing up interest rates and the dollar.

"We seek to limit the downside from any interest rate shifts and beat our benchmarks by focusing on the credit profile of individual securities and taking advantage of a mispricing of risk."

Regardless of the future movement of rates, we will stick to our emphasis on assessing credit risk. We believe such an approach is especially promising during times of market turbulence.

For example, we bought bonds issued in 2006 by Queens Ballpark LLC, the leaseholder of Citi Field, the stadium of the New York Mets. The bonds, which fit the risk/return characteristics we look for, were offered on the secondary market amid the post-election selloff.

We believe the bonds pose limited credit risk. The securities derive revenue from parking, concessions and ticket revenue, and include a leasehold lien on the stadium. Attendance has risen in recent years, and the Mets have signed an agreement to remain at the stadium beyond the 2039 maturity date of the bonds. Moreover, Queens Ballpark LLC will only make distributions to equity holders if it can project cash flows sufficient for payment to bondholders for at least 12 months. This provision helps align the interests of equity holders and bondholders.

We also purchased bonds issued by Kraton Corp., a chemical producer. Kraton recently completed a debt-funded acquisition that left it with high leverage and a low credit rating, but, in our view, an attractive risk-adjusted return. We expect the company will deleverage and refinance the bonds in less than three years thanks to several tailwinds, including cost cutting, stable demand and robust free cash flow generation. Its solid prospects and lack of interest rate sensitivity make it a haven during a time of Treasury market tumult.

Even during a period of rising rates, investors willing to make a commitment to bonds for at least two years should outperform cash through the accrual of income. A portfolio of bonds should achieve a higher total return even as interest rates rise because, eventually, the income generated will exceed the principal that was lost as rates increased. We believe that, over time, a fixed income portfolio with solid credit characteristics will shine through even the stormiest markets.


Private investments mentioned in this article may only be available for qualified purchasers and/or accredited investors.

The views expressed are those of the author and Brown Advisory as of the date referenced and are subject to change at any time based on market or other conditions. These views are not intended to be and should not be relied upon as investment advice and are not intended to be a forecast of future events or a guarantee of future results. Past performance is not a guarantee of future performance and you may not get back the amount invested. The information provided in this material is not intended to be and should not be considered to be a recommendation or suggestion to engage in or refrain from a particular course of action or to make or hold a particular investment or pursue a particular investment strategy, including whether or not to buy, sell, or hold any of the securities mentioned. It should not be assumed that investments in such securities have been or will be profitable. To the extent specific securities are mentioned, they have been selected by the author on an objective basis to illustrate views expressed in the commentary and do not represent all of the securities purchased, sold or recommended for advisory clients. The information contained herein has been prepared from sources believed reliable but is not guaranteed by us as to its timeliness or accuracy, and is not a complete summary or statement of all available data. This piece is intended solely for our clients and prospective clients, is for informational purposes only, and is not individually tailored for or directed to any particular client or prospective client.