It’s the “Real” Yield That Matters

Length 4:01
Jeffrey Sherman , Deputy Chief Investment Officer, DoubleLine®

Jeffrey Sherman: So this is the biggest challenge and conundrum of running a fixed income portfolio because people have focused for the last, you know, let’s call it five or so years, probably the whole 16 years of my fixed income career, people are saying what if interest rates go up. I’ve read the theoretical example, you know, if interest rates go up, my price goes down in my bonds, I lose money but when you start to build a portfolio, you have to build for what you see as the macro economic environment, and so if interest rates are going up for the right reason, typically when I call it the right reason what I’m referring to is that we have an improving economy, right, global economy or single kind of country economy going upward tends to lead to higher interest rates, so that’s a positive attribute for certain types of fixed income securities, especially if you’re lending money to corporations, you’re lending money to folks who would benefit and have a higher propensity to pay back the securities under this better economic environment.

And so people have gotten too focused on the absolute level of yield being low or lower than what some people have seen in their careers, but when you go back through history and you go back and look at the history of U.S. interest rates or the history of the U.K. interest rates, we have long histories going back 150 to 250 years, what you find is it’s typically the real yield that matters and what I mean by real is the level of interest you get minus the inflation rate, and that tends to be about the level we see in the markets today. And so the idea that people are focused on this low level, it’s because we actually have a lower level of inflation than we’ve had really through this long period of time, and so the markets trade always on a relative value basis, and it’s that compensation over inflation that one actually receives. So that doesn’t make someone feel good about it, if you’re used to getting 5 or 6% on investment securities but 4 or 5% inflation, you still feel like you’re making some progress. Well if the bottom market is giving you 3% and it’s a 2% inflation, the bottom market is trading absolutely the same, and so for investors what you have to worry about is inflation sneaking into the portfolio because that is the one thing that can spike interest rates very quickly, and we saw that in the U.S. with the election of President Trump. People were starting to believe that his policies would lead to higher inflation rate and it reset interest rates for a short period of time.

What’s happened in early 2017 though is investors have started to question the efficacy of the implementation of the policy. As you may be well aware, President Trump, he talks a very good game but thus far his execution has fallen pretty flat. So when we talk about policies, what we have to do is be cautious on how effective the implementation will be, and so this is where when building a portfolio, what you want to do is you want to balance the risk in your portfolio, you want to tilt towards the directions you think are likely outcomes but you don’t want to put all your eggs in one basket and so from the perspective of President Trump, it’s still a wild card, there’s still euphoria and some optimism in the financial markets based upon his policies, however thus far it’s been very difficult for any implementation to come through. So we remain a bit skeptical on the euphoria however he still has a chance, he’s only been in office for a very few months.