Interest Rates: Low for Long


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Historical data shows that interest rates have tracked GDP for the last 40 years. The slow growth environment suggests GDP and interests rates should stay low for the foreseeable future. Investors should consider nontraditional sources of income in this new slow growth environment.

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Interest Rates: Low for Long

  1. 1. Q&A with Krishna Memani, CIO Conventional wisdom in the investing world expects interest rates to rise over the next two to three years. Several pundits cite history and the slowly improving domestic economy as their evidence. However, that position ignores some very important reasons to believe interest rates could remain low for much longer than anticipated. This lack of a return to normal has significant investment repercussions and makes some asset classes, including senior loans and master limited partnerships, particularly attractive, says Krishna Memani, OppenheimerFunds’ CIO, who started in the financial services industry in 1987. Memani oversees the firm’s investment teams, which collectively manage more than $232 billion (as of 12/31/13). He believes rates will stay low due to several factors. QInterest rates worldwide have been near historic lows since 2008. Why do you expect this low rate environment to continue? AOver the long term, interest rates are a function of economic growth and inflation. Historically, if you look at the relationship between nominal Gross Domestic Product (GDP) and interest rates, they tend to track each other very closely. Since 2008, both developed and emerging economies have seen a slowdown relative to their trend growth rates prior to the financial crisis. With the exception of a few places like India or Brazil, global inflation is also quite low. In fact, in some countries, like Japan and the United States, inflation is actually running below central bank expectations. Low Rates For A Long TIME And Preparing for the Eventual Rise Fixed income Chart 1 As GDP Goes, Rates Go Nominal U.S. GDP and interest rates have tracked each other over the long term. Sources: U.S. Bureau of Economic Analysis, Federal Reserve Bank, ISI Group, as of 6/30/13. Nominal GDP is smoothed over 10 years. GDP refers to gross domestic product, which is the monetary value of all the finished goods and services produced within a country’s borders. Forecasts may not be achieved. Past performance does not guarantee future results. 0 3 6 9 12 15% 1947 1952 1957 1962 1967 1972 I 10-Year U.S. Treasury Yield I Nominal GDP 1977 1982 1987 1992 1997 2002 2007 2012 2017 2022 Not FDIC Insured May Lose Value Not Bank Guaranteed
  2. 2. 2 that they will keep monetary policy accommodative until we reach a 6.5% unemployment level or breach a 2.5% level for inflation. QHow might a slowdown in China impact the world? AChina is currently grappling with its own structural issues. Most importantly, investment as a percentage of GDP is currently tracking at about 49%.1 This is much too high. For China to have a stable economy over the long term, it will be necessary for this to shrink and consumption as a percentage of GDP to grow. Policymakers in China understand this and are implementing policy actions to slow the economy and allow for consumption to grow over time. Unfortunately, for the rest of the world this means that global growth is likely to slow with China, and that has implications for a slowdown across the emerging world and in the commodity super cycle. Economic growth trends and central bank policies in Europe and Japan both play key roles in the direction of interest rates. In aggregate, the Eurozone is the largest economy in the world, making it relevant to the direction of interest rates. It appears European nations have avoided a break up, but there are still significant issues that need to be addressed. Most importantly, flows continue to move from the weaker countries to the stronger countries. Given this back- drop, it is quite likely that central bank policy for the region will continue to be dictated by its weakest members. The Japanese have outlined a three- pronged approach—dubbed “the three arrows”—to help address their current economic position. The first of the policies to be implemented was the large-scale asset purchases by the Bank of Japan (BOJ), which has been extremely successful, increasing the BOJ’s balance sheet substantially. The challenge for the BOJ will be to keep inflation from spiraling out of control while keeping the yen from depreciating too quickly. QWhat is your outlook for U.S. interest rates? AMy base case scenario right now is that growth in the U.S. will continue to be in the 1.5%–2% range. This level of growth is below long-term trends, and in the near term, I don’t see a major catalyst to break us out of this rut. Additionally, many people were counting on housing to be the driving force behind a strong recovery in the United States. Unfortunately, housing recoveries tend to have a small direct impact on GDP. With mortgage rates in the U.S. rising rather dramatically since the Fed began talk of a QE taper, we’ve already seen a slowdown in refinancing activity and this will also increase the cost of housing to many potential buyers. The Fed has also stated QWhat about clients who are still concerned about rising rates? What fixed income asset classes do you recommend for them? A Although my view on interest rates is low for long, I understand clients’ concerns regarding rising rates. Irrespective of the direction of interest rates, the best opportunity in the fixed income universe right now is in credit. Senior floating rate loans are particu- larly attractive in today’s market. They offer a hedge to rising rates as their coupon floats with 90-day LIBOR, they are senior in the capital structure and are usually collateralized by assets of the issuer. Finally, they presently pay a coupon that outpaces the current level of inflation. As an asset class, these loans have historically displayed low correlations to U.S. Treasuries, investment-grade government debt, investment-grade corporate bonds and stocks. Chart 2 Senior Loans Have Historically Outperformed Government Bonds During Periods of Rising Rates Periods of rising treasury rates Source: Bloomberg, 12/31/13. The Credit Suisse Leveraged Loan Index is an unmanaged index that tracks the performance of senior floating rate bank loans. The Barclays U.S. Treasury Index represents public obligations of the U.S. Treasury with a remaining maturity of one year or more. The indices shown are unmanaged and cannot be purchased directly by investors. Index performance is shown for illustrative purposes only and does not predict or depict the performance of any investment. Past performance does not guarantee future results. –5 0 5 10 15% 10.70 –3.70 6.81 –2.70 3.25 –1.84 –3.37 6.57 0.780.93 9/93–11/94 12/95–8/96 9/98–1/00 5/03–6/06 4/13–8/13 I Credit Suisse Leveraged loan Index I Barclays U.S. Treasury Index
  3. 3. 3 QBesides credit, which other asset classes might make sense for clients who feel a strong need to position themselves for a rising rate scenario? A Alternative investments, such as master limited partnerships (MLPs), feature several appealing properties. Many currently offer attractive yields. MLPs enjoy favorable tax treatment, and many appear to have good busi- ness prospects since they are tied to the significant increases in production and distribution of domestic oil and natural gas. Plus, over the last decade, there has been no material correla- tion between changes in interest rates (as represented by the 10-year U.S. Treasury rate) and MLP yields (as represented by the benchmark Alerian MLP Index2 ). QWhat’s the bottom line for investors? A Real income will be the likely driver of future returns for investors. Although the case has been laid out for why interest rates will stay low for long, it is certainly possible that interest rates could move up more quickly and ultimately, over the long term, it’s true that rates have nowhere to go but up. Whether rates stay low for long or not, prudence in either scenario calls market participants to consider invest- ment options that seek to provide real income, such as senior loans or MLPs. Both asset classes offer features that could potentially insulate investors against the negative effects associated with a rising rate scenario. Chart 3 MLPs Have Historically Performed Well During Periods of Rising Interest Rates Source: Bloomberg, Alerian Capital Management, Barclays Research estimates, as of 12/31/13. Chart shows Alerian MLP Index Total Return (AMZX) performance. Interest rates are represented by the 10-Year U.S. Treasury. An investor cannot invest directly in an index. They are unmanaged and shown for illustrative purposes only and do not predict or depict the performance of any investment. Short-term interest rates and longer term treasury rates may or may not move in tandem directionally or in magnitude. Past performance does not guarantee future results. Chart 4 Opportunities for Real Income Yields as of 2/28/14. Source: BLS, Barclays Live, Bloomberg, and Morgan Markets (as of 2/28/14). The Barclays U.S. Treasury Index represents public obligations of the U.S. Treasury with a remaining maturity of one year or more. The Barclays U.S. Aggregate Bond Index is an investment-grade domestic bond index. The Credit Suisse Leveraged Loan Index is an unmanaged index that tracks the performance of senior floating rate bank loans. The indices shown are unmanaged and cannot be purchased directly by investors. Index performance is shown for illustrative purposes only and does not predict or depict the performance of any investment. Past performance does not guarantee future results. * Alerian MLP Index data is as of 1/31/14. 0 1 2 3 4 5 6 7% CPI = 1.6% 7% Alerian MLP Index* Credit Suisse Leveraged Loan Index Barclays U.S. Aggregate Bond Index Barclays U.S. Treasury Index 1.3% 2.3% 5.5% 5.9% 0 400 800 1,200 1,600 AMZ PERFORMANCE DURING PERIODS OF RISING INTEREST RATES* +5% –3% –4% +54% +30% +11% +23% ValueofAlerianMLPIndex Jan1996 Jan1997 Jan1998 Jan1999 Jan2001 Jan2000 Jan2002 Jan2003 Jan2004 Jan2005 Jan2006 Jan2007 Jan2008 Jan2009 Jan2010 Jan2011 Jan2012 Jan2013 Jan2014 I Alerian MLP Index Total Return (AMZX) I Rising Rates
  4. 4. ContactUS Visit Call 800.225.5677 Follow us: Visit Search Google Currents for OppFunds to access our timely thought leadership Visit | Call 800.225.5677 Scan this code to learn more about us: Read more insights from Krishna Memani at 1. Source: The World Bank 2/28/14. 2. The Alerian MLP Index (AMZ) is a composite of the 50 most prominent energy Master Limited Partnerships that provides investors with an unbiased, comprehensive benchmark for this emerging asset class. The index is unmanaged and cannot be purchased directly by investors. Index performance is shown for illustrative purposes only and does not predict or depict the performance of any investment. Past performance does not guarantee future results. Fixed income investing entails credit risks and interest rate risks. When interest rates rise, bond prices generally fall, and a fund’s share prices can fall. Investments in below-investment-grade (“high yield” or “junk”) bonds are more at risk of default and are subject to liquidity risk. Foreign investments may be volatile and involve additional expenses and special risks, including currency fluctuations, foreign taxes and political and economic uncertainties. Emerging and developing market investments may be especially volatile. Diversification does not guarantee profit or protect against loss. Senior loans are typically lower rated and may be illiquid investments (which may not have a ready market). Investing in MLPs involves additional risks as compared to the risks of investing in common stock, including risks related to cash flow, dilution and voting rights. Each fund’s investments are concentrated in the energy infrastructure industry with an emphasis on securities issued by MLPs, which may increase volatility. Energy infrastructure companies are subject to risks specific to the industry such as fluctuations in commodity prices, reduced volumes of natural gas or other energy commodities, environmental hazards, changes in the macroeconomic or the regulatory environment or extreme weather. MLPs may trade less frequently than larger companies due to their smaller capitalizations which may result in erratic price movement or difficulty in buying or selling. Additional management fees and other expenses are associated with investing in MLP funds. The Oppenheimer SteelPath MLP Funds are subject to certain MLP tax risks. An investment in an Oppenheimer SteelPath MLP Fund does not offer the same tax benefits of a direct investment in an MLP. The Funds are organized as Subchapter “C” Corporations and are subject to U.S. federal income tax on taxable income at the corporate tax rate (currently as high as 35%) as well as state and local income taxes. The potential tax benefit of investing in MLPs depend on them being treated as partnerships for federal income tax purposes. If the MLP is deemed to be a corporation, its income would be subject to federal taxation at the entity level, reducing the amount of cash available for distribution which could result in a reduction of the fund’s value. MLP funds accrue deferred income taxes for future tax liabilities associated with the portion of MLP distributions considered to be a tax-deferred return of capital and for any net operating gains as well as capital appreciation of its investments. This deferred tax liability is reflected in the daily NAV and as a result a MLP fund’s after-tax performance could differ significantly from the underlying assets even if the pretax performance is closely tracked. Shares of Oppenheimer funds are not deposits or obligations of any bank, are not guaranteed by any bank, are not insured by the FDIC or any other agency, and involve investment risks, including the possible loss of the principal amount invested. These views represent the opinions of OppenheimerFunds and are not intended as investment advice or to predict or depict the performance of any investment. These views are as of the open of business on March 20, 2014, and are subject to change based on subsequent developments. Before investing in any of the Oppenheimer funds, investors should carefully consider a fund’s investment objectives, risks, charges and expenses. Fund prospectuses and summary prospectuses contain this and other information about the funds, and may be obtained by asking your financial advisor, visiting or calling 1.800.CALL OPP (225.5677). Read prospectuses and summary prospectuses carefully before investing. Oppenheimer funds are distributed by OppenheimerFunds Distributor, Inc. 225 Liberty Street, New York, NY 10281-1008 © 2014 OppenheimerFunds Distributor, Inc. All rights reserved. DS0001.408.0314  March 20, 2014