VOICEOVER: Welcome back to The Investment Conversation. I’m Tony Fisher.

AUDIO SNIPPET:

Paulson: You can't just say, "Hey, I just read that the Fed's going to be hiking next year." Or "I'm convinced the Fed will hike. And therefore I need to sell all of my short-term assets because yields are going to go higher."

[Brief pause]

No, they're really not necessarily going to go higher at all.

VO: Investors are increasingly focused on the likelihood that the U.S. Federal Reserve will begin hiking the Fed funds rate as it seeks to remove the monetary accommodation provided in response to the COVID-19 pandemic. But do Fed rate hikes equal trouble for short-term bonds? The answer may lie in two time-honored subjects: math and history. My colleague Will Andrews sat down with Lord Abbett Investment Strategist Tim Paulson for some instruction on Fed hikes and short bonds.

Will Andrews: So Tim, you recently wrote a market view for LordAbbett.com that attracted a lot of attention here at 90 Hudson Street and among our investors. Of course, investors are always eager to hear about the Federal Reserve's next moves and how policy changes might affect their portfolios. But the premise of your article might be a bit surprising to many people. Tell us about it.

Timothy Paulson: Sure, Will. As for the surprising part-- perhaps it's simply the fact that markets are efficient. And maybe what you read in alarmist headlines isn't always exactly what's going to happen to your portfolio. Really all we're talking about here is that when we're dealing with large markets such as U.S. Treasury market, valuations are incredibly efficient.

When there's information out there, yields and prices instantly move to reflect that information. So when we're talking about something as heavily scrutinized as the Fed, we can say, "Gee, you know, the Fed's going to hike a couple times over the next few years." Well, the Treasury market knows that too. And whatever yield two-year Treasuries, for example, might have at any point in time already reflects that expectation.

Andrews: So has that efficiency been helped I think budget the Fed's move to be more transparent about their interest rate intentions?

Paulson: Oh yeah, certainly. Rewind several decades when there was a lot of Ouija board usage trying to determine what the Fed might or might not be intending. Now the Fed is extremely clear. They release dot plots. They manage expectations even between meetings with [press conferences and] speeches, with leaks to journalists. But even beyond that, you know, what we're talking about now is a pretty gradual pace of Fed hikes. I'll give you a new example. Two-year Treasury yields have risen considerably, on a relative basis, to start the month of October--you know, from the start of October through the end of October. Commensurate with that rise was a change in expectations around how many times the Fed would hike by the end of next year. And perhaps a little more following year.

If you just take a simple average of the expected Fed funds rate over the next two years. You know, very low now, higher next year, higher than that the year after. And just average all those Fed funds, right? It's going to look like the two-year Treasury yield.

Andrews: So that's the sort of bond math that you spoke of in Market View. Which, once again, investors can find o LordAbbett.com. So just maybe talk a little bit more about that, and how that really helps shape investor expectations, and ultimately, prices.

Paulson: Well, I guess one takeaway's that there's no free lunch. Which shouldn't be surprising to any investor. You can't just say, "Hey, I just read that the Fed's going to be hiking next year." Or "I'm convinced the Fed will hike, and therefore I need to sell all of my short-term assets because yields are going to go higher."

No, they're really not necessarily going to go higher at all. Necessary they know that the Fed's going to hike too. That's already embedded in current valuations. And, you know, for any kind of proof you can just look back. All kinds of historical Fed meetings where the Fed cuts or hikes exactly as expected. And two-year yields don't move at all. Why should they move? Because no new information has come into the marketplace.

Andrews: So it's interesting that you brought up the historical experience. Because I guess, your article also contains a bit of a history lesson for us as well. And that is about returns for short-term bonds in years when the Fed actually has been hiking. Talk a little bit about that.

Paulson: Well, we can say conceptually that we understand that Fed hikes are kind of reflected in today two-year Treasury valuations, as an example. And right now again, you know, two hikes by the end of the of next year. A few more hikes by the end of 2023.

And that's all reflected. But it still can be difficult for some investors to say, "Yeah, I get that that's priced in. But still, the Fed's hiking. And, you know, a year from now the yield on two-year Treasuries is going to be higher than it is now. And I don't want to be in that kind of losing investment."

Well, part of the reasons it's not so much a losing investment if because if you buy a two-year Treasury today, a year from now you don't own a two-year Treasury. You own a one-year Treasury. It's a different kind of security. Whereas if you're comparing it to a two-year Treasury that doesn't exist yet.

But it can be helpful just to look at where yields are. Or how things have performed in the past, I should say. So we, in the last few decades, in this era of Fed transparency, we've had two very different periods where the Fed was telling us they were going to hike.

The market expected they were going to hike. And, sure enough, they hiked. And in fact, from, you know, 2002 through 2006, you know, the Fed hiked every meeting for several years. They took the Fed funds rate from 1% to up above 6%.

And, you know, that's a really substantial move. Multiple rate hikes every year. And yet investors who put their money, even in just two-year Treasuries, made money every year. Now, maybe there was a little bit of price drag. There were certainly some times when, you know, the market expected that the Fed might be done hiking at 4.5% or 5%.

And that-- they realized there was more. And so two-year Treasury yields sold off even more. But even that kind of price move wasn't enough to offset the fact that you're starting with a nice yield. Yields aren't that compelling right now. But you're still earning something.

And that income, part of fixed income, very often gets forgotten. You know, people worry so much, think so much about prices. And they forget about the fact that, you know, time passes and we receive income. And securities kind of roll towards maturing. So you can look at any kind of historical performance for two-year Treasuries, short-term corporate bonds, other short-term asset classes. They're positive if you look at any calendar year during these hiking cycles.

Andrews: I was actually going to ask about the experience of other short-term bonds besides Treasuries and- how have they responded. So it seems that even during these times of Fed hiking regimes that investors really haven't been treated so badly, have they?

Paulson: No, they really haven't. And, you know, again, I talk about the word income. That is the magic term when you're talking particularly about short-term investments. You know, at the end of the day the prices really can't move very much. You're dealing with short bonds.

You know that they're going to be worth par. At a fairly, you know, soon point in the future. So getting more income typically serves you pretty well. You know, when the Fed's hiking it's usually because the economy's doing pretty well. And, you know, maybe inflation expectations are rising a little bit.

I'm not going to get into where we are now with that. Certainly there are some understandable concerns about inflation. But then again, that doesn't impact investments on the front end. This is really just a function of how much income are you receiving.

And how much might yields be rising. The only way you lose is if yields rise so sharply that it offsets, you know, your starting income. Of course, it helps to have starting income. So yes, corporate bonds, they do even better than Treasuries in those kinds of environments.

You know, yield-based assets, commercial mortgages, mortgages, asset-backed securities, they all have positive returns. Because we're not having a big credit spread widening event that you would typically see when everyone worries about an imminent recession. You know, this is just a steady thing – the Fed's already telegraphed that they're going to be hiking. The market's priced in these hikes. And as they realize, well, that's fine.

Andrews: So this is actually a terrific discussion I think to have to sort of help put people at ease about prospect of Fed hikes and their effects on fixed income portfolios. But, you know, obviously beyond the Fed there are other factors that are at play right now in fixed income markets.

Worries about inflation. You know, concerns about the pace of U.S. growth. And whether the third quarter slowdown is just transitory, to borrow another word from the inflation discussion. So given all these factors, let's just have a quick recap. What should fixed income investors be thinking about in the weeks and months ahead?

Paulson: Ooh. Well, there's a lot to think about. When we're thinking about, you know, the weeks and months ahead, the big drivers tend to be, you know, how does a price on my bond move? What the make that change? And, you know, if you're dealing with just Treasuries, well, it's pretty straightforward again.

You know, if you're on the front end it's going to be, “do we have any changes in expectations for how the Fed might react?” If we're dealing with longer term bonds, well, you have a whole host of new variables. And that gets a little tricky. So I think one thing that investors should have in mind is all of the different ways that any dynamics in the marketplace and the economy could impact the valuations for longer term Treasuries.

And then because the bond market consists of a lot of stuff that's not Treasuries, what might impact the credit quality of those other assets? Certainly if there's a slowdown. An economic slowdown. Q3 is just the early stages of something and we get some fiscal drag.

Or, you know, consumers just are not feeling comfortable spending because headlines are bad and employment hasn't rebounded the way that the-- whatever the story is, that actually in turn makes it less likely that the Fed's going to start hiking.

So you see you get a little bit of balance there. But generally speaking, it's hard to be negative on credit. At least right now. Because of course corporate balance sheets are so healthy. And consumer balance sheets are very healthy.

There's a lot of cash. Credit card debt's reduced. And a lot of job availability. So as we think about the coming weeks, months-- we're going to see a lot of headlines around inflation. Maybe the market has, you know, been overly focused recently on certain supply chain hiccups.

But there are a lot of other things percolating in the system that won't easily rectify themselves quickly. You know, you can't just shut things down for an extended period of time, you know, flip a button and have everything just start working.

If-- you know, I fall asleep on my arm I'm not going to wake up and just have it feel wonderful and start moving right away. And that's a little bit of what we're seeing happening with the economy. So these are all dynamics that are going to keep things uncertain and volatile.

The nice thing is that at least if you're on the front end of the curve, you know, again, there's this idea, oh gosh, the Fed's going to hike. Get out of the front end of the curve. Well, no. The Fed is so transparent and we have such a clear idea about what's happening, that's likely to be the least volatile of a lot of the investments. You know, again, I just highlighted a neighbor of things that could give rise to some uncertainty. Well, if you're on the front end of the curve, you have a tremendous amount of predictability.

Andrews: Well, Tim, this has been a terrific discussion. And I learned a lot here. Even a little bit of math. And so I want to thank you for being with us today on "The Investment Conversation."

Paulson: Thanks for having me, Will.

Andrews: As a reminder, our listeners can access white papers and investment commentary from Tim Paulson and other Lord Abbett thought leaders by visiting our website, LordAbbett.com. Or by contacting their Lord Abbett representative. Be sure to listen to other episodes in our recent series of investment conversation podcasts. Giulio Martini talking about the “Humpty Dumpty” U.S. economy. And Joe Graham on some important considerations for investors in core bonds.

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