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Fixed-income investors currently face a delicate balancing act. They require sufficient yield to support a positive real return—but if they extend too high in credit quality or too far along the yield curve, investors likely will expose themselves to heightened interest-rate risk. Given these considerations, are there guidelines that investors might use to potentially tip the scales in their favor?
One such approach involves directly comparing an investment's yield to its duration. The takeaway is that a higher yield, relative to duration, may provide the necessary income to more than offset the price decline associated with rising rates. Such a conclusion can be especially relevant if the Federal Reserve slowly unwinds its aggressive easing policies of the past several years and we return to a more normal environment with less influence from the Fed.
A market environment with less Fed intervention could create a scenario wherein interest rates "normalize" over the course of five years, potentially resulting in a fed funds rate of 4%, which is the Fed's long-term projection, and a 10-year Treasury yield of about 5%, which is an assumption based on historical yield curve relationships and the relationship between the real 10-year Treasury yield and gross domestic product (GDP). And as this theoretical scenario unfolds, the difference between an investment's yield and duration could have a significant bearing on its potential price changes, income generation, and, therefore, cumulative total return.
For example, the assumed duration of the 10-year Treasury note, 8.4 years, multiplied by an estimated 300 basis-point change in interest rates over five years could result in a price loss of about 25%. When the rising income generated over that time frame is factored in, a five-year cumulative return on the 10-year note could still amount to a loss of more than 6%. A similar scenario could also prove disappointing to investments benchmarked to the Barclays U.S. Aggregate Bond Index, which (as of May 2013) consisted of about 75% government-related securities, as it could inch toward a cumulative gain of less than 4% over five years.
This meager estimated result means that investments benchmarked to the Barclays U.S. Aggregate Bond Index would have a very low performance hurdle of less than 1% per year in order to claim that the investments beat their benchmark over that period. While essentially treading water in a rising rate environment could disappoint many investors, those with TIPS [Treasury Inflation-Protected Securities] exposure could be in for an even ruder awakening, given the estimated loss of 12%.
Conversely, asset classes with yields that are higher than, or close to, their durations, may have a higher likelihood of posting positive real returns during the theoretical five-year normalization period. This dynamic is reflected in the estimated total return for floating-rate loans, high-yield bonds, and short-term corporate bonds with 'BBB' credit ratings.
While the guideline advocating that an investment's yield exceed its duration does not encapsulate the entire risk/reward spectrum for each position or allocation in a portfolio, the guideline could keep investors relatively insulated from the risk of normalizing interest rates. And the more investors hear from the Fed, the more it appears that they anticipate that the central bank is approaching a decision about curtailing its market participation and letting traditional market forces determine the appropriate level of long-term interest rates.
Five-year returns of select investments as yields normalize*
Source: Bloomberg, Barclays Capital, Credit Suisse, and Lord Abbett.
For illustrative purposes only and does not reflect any Lord Abbett mutual find or any particular investment. Past performance is no guarantee of future results. The value of an investment in fixed-income securities will change as interest rates fluctuate and in response to market movements. As interest rates fall, the prices of debt securities tend to rise. As rates rise, prices tend to fall. High-yield securities, sometimes called junk bonds, carry increased risks of price volatility, illiquidity, and the possibility of default in the timely payment of interest and principal. Moreover, the specific collateral used to secure a loan may decline in value or become illiquid, which would adversely affect the loan's value. Like traditional Treasury bonds, Treasury Inflation-Protected Securities (TIPS) are issued by the U.S. Treasury and are guaranteed by the U.S. government. Although, TIPS are inflation-linked bonds that are fixed-income securities whose principal value is periodically adjusted according to the rate of inflation. In contrast, a Treasury bond's principal value is fixed. TIPS can be volatile and decline in value over the short term. This typically happens when interest rates rise.
Please note that forecasts and projections are based on current market conditions and are subject to change without notice. Market projections should not be considered a guarantee.
A Note about Risk: Investing involves risk, including the possible loss of principal. The value of an investment in fixed-income securities will change as interest rates fluctuate and in response to market movements. As interest rates fall, the prices of debt securities tend to rise. As rates rise, prices tend to fall. Bonds may also be subject to call, credit, liquidity, and general market risks. Longer-term debt securities are usually more sensitive to interest-rate changes; the longer the maturity of a security, the greater the effect a change in interest rates is likely to have on its price. High-yield securities, sometimes called junk bonds, carry increased risks of price volatility, illiquidity, and the possibility of default in the timely payment of interest and principal. Moreover, the specific collateral used to secure a loan may decline in value or become illiquid, which would adversely affect the loan's value. Mortgage-backed securities are subject to prepayment risk. Although U.S. government securities are guaranteed as to payments of interest and principal, their market prices are not guaranteed and will fluctuate in response to market movements. No investing strategy can overcome all market volatility or guarantee future results.
Treasuries are debt securities issued by the U.S. government and secured by its full faith and credit. Income from Treasury securities is exempt from state and local taxes.
Treasury Inflation-Protected Securities (TIPS) are Treasury securities that are indexed to inflation in order to protect investors from the negative effects of inflation. TIPS are considered an extremely low-risk investment since they are backed by the U.S. government and since their par value rises with inflation, as measured by the Consumer Price Index, while their interest rate remains fixed.
There is no guarantee that the asset classes discussed will perform in a similar manner under similar conditions in the future.
Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.
Glossary of Terms:
A yield curve is a measure at a given point in time of how interest rates change based on maturity terms.
Gross domestic product (GDP) measures the good and services produced in an economy over a specific timeframe.
A basis point is one one-hundredth of a percentage point, and 100 basis points is equivalent to 1%.
A real yield is the nominal yield minus the rate of inflation.
Duration is the change in the value of a fixed-income security that will result from a 1% change in interest rates, taking into account anticipated cash flow fluctuations from mortgage prepayments, puts, adjustable coupons, and potential call dates.
The opinions in the preceding commentary are as of the date of publication and subject to change based on subsequent developments and may not reflect the views of the firm as a whole. This material is not intended to be legal or tax advice and is not to be relied upon as a forecast, or research or investment advice regarding a particular investment or the markets in general, nor is it intended to predict or depict performance of any investment. Investors should not assume that investments in the securities and/or sectors described were or will be profitable. This document is prepared based on information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy or completeness of the information. Investors should consult with a financial advisor prior to making an investment decision.
Investors should carefully consider the investment objectives, risks, charges, and expenses of the Lord Abbett funds. This and other important information is contained in each fund’s summary prospectus and/or prospectus. To obtain a prospectus or summary prospectus on any Lord Abbett mutual fund, contact your investment professional or Lord Abbett Distributor LLC at 888-522-2388 or visit us at www.lordabbett.com. Read the prospectus carefully before you invest.