June 8, 2018
By Paul Horng and Cal Spranger

After several years of false break outs, it finally appears that U.S. interest rates are on the rise. The 10-year Treasury hit 3.11% on May 17, a level last seen in 2011. Aside from a brief flight to quality at the end of May, tied to concerns over Italian politics, the yield on the benchmark 10-year Treasury bond is trending back towards 3.00%.

Higher interest rates have been driven by several factors including cyclically low unemployment rates (3.8%), increasing inflation, the normalization of the Federal Reserve balance sheet as well as prospects of higher U.S. borrowing connected to the projections of widening fiscal deficits. While the breakneck pace of global economic growth in 2017 has become more subdued, healthy U.S. economic data confirm a continued economic expansion.

With fears related to Italy and trade wars abating, at least temporarily, the Federal Reserve is expected to increase the current fed funds rate range of 1.50% to 1.75% by 0.25% in their meeting next week. If the Federal Reserve raises rates next week, one or two additional hikes are anticipated for 2018.

In our view, the move in interest rates has neither been shocking nor unexpected and has been reinforced by the data. The 10-year Treasury hitting a symbolic level of 3% is no cause for nail-biting. Instead, rates are reflecting the healthy and improving wage, inflation and growth picture in the U.S. None of these have given us cause for concern to date, though inflation always bears a watchful eye. Overall, economic data, monetary policy and easing trade tensions, remain supportive of fixed income investment, but in the context of an environment with increased market volatility.

The opportunity set for investors has become more appealing with fixed income interest rates trending higher. At Badgley we employ a conservative approach during a rising interest rate environment. In addition to focusing on high-quality investment-grade bonds, which in the past have acted as a ballast during bouts of stock market volatility, we take a laddered approach. Instead of buying bonds that all mature during a single year, our bond portfolios are constructed to hold a variety of bonds with staggered maturities. In a rising interest rate environment, the laddered portfolio allows the maturing lower-yielding bonds and semi-annual interest payments to be reinvested at today’s higher interest rates.  

Gradually rising interest rates fueled by continued U.S. economic growth should not be cause for concern. Barring an idiosyncratic shock, interest rates will likely continue to increase at a gradual pace and will be guided by economic growth, inflation expectations, productivity growth and the impact of fiscal stimulus. A laddered portfolio of high-quality investment-grade bonds should be well positioned to benefit from such an environment.