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Fixed-Income Insights

Forward interest rates indicate that investors expect a significant rise in yields in the next two years. How much of an impact could that have on total return for current investments? 

 
In Brief
  • Financial markets expect that interest rates will rise in the coming years as the Federal Reserve moves to “normalize” monetary policy by raising the fed funds rate.

  • One way to measure just how much the market expects interest rates to rise is by looking at forward interest rates (see sidebar, “Interest Rates: The Way Forward”).

  • What do forward rates indicate now? Data on interest rate swaps compiled by Goldman Sachs show that investors expect significant increases in two-, five-, and 10-year swap rates in the next two years.

  • What could that mean for returns on some fixed-income investments? After accounting for the potential negative effects on performance from the effect of higher interest rates based on current forward-rate expectations, two hypothetical strategies for shorter-duration and intermediate-duration securities would see positive returns over the next two years, even amid a bond-market selloff that produces a significant rise in bond yields.

  • The key takeaway—Despite market concerns about the timing and size of Fed rate hikes, current expectations for forward interest rates suggest that the impact of a future bond market selloff on returns of certain fixed-income strategies may not be as bad as feared. As long as the expected income from a fixed-income security exceeds the potential loss from a rise in interest rates, a bondholder should be best served by staying invested.

 

The Federal Reserve’s quantitative easing (QE) program has come to an end, and investors have turned their attention to the timing and magnitude of future interest-rate hikes. Naturally, the prospect of increases in the fed funds rate raises concerns about a potential bond market selloff. But for all of the doom-and-gloom prognostications from financial commentators about why investors need to flee fixed income, I’ve seen very little effort to quantify the impact a selloff could actually have on bond investors’ total return. I thought it would be useful to examine a closely watched market indicator to provide a quick, back-of-the-envelope analysis on what a selloff could look like—and what a pronounced rise in yields would do to performance. 

The most obvious place to start is with forward rates, a mathematical construct that simply calculates a breakeven interest rate in the future, typically based on quoted yields for interest-rate swaps. (For more on forward rates, see the sidebar, “Interest Rates: The Way Forward.”) Why is this important? Simply put, the fixed-income market is very efficient. (The notion of an efficient market hinges on investors using all available information to determine security prices.) Remember, security valuations basically are an aggregation of all dollars invested in bonds by everyone from Joe Average to Mr. Hedge-Fund Titan. There is a vast amount of information that can help to determine prices. Forward interest rates reflect that aggregation of information in terms of the market’s future expectations. Historically, forward rates have at times had a far better predictive track record than the average economist in predicting interest-rate movements. (See sidebar.)

Right now, the market is implying one- and two-year forward interest rates that are higher than today’s rates. This is unsurprising, given the prevalent view that the bond market will experience a selloff as the Fed tightens monetary policy. But how much could yields rise when this happens? Looking at the difference between “spot” rates (reflecting current yield levels for a particular maturity) and investor expectations of yields one and two years hence is a fairly good way to quantify what a real selloff might look like:

 

Table 1. Forward Interest Rates Show That Investors Expect Yields to Rise
Quoted swap rates at varying maturities as of November 10, 2014

Source: Goldman Sachs. A forward rate is applicable to a financial transaction that will take place in the future. Forward rates are based on the spot rate, adjusted for the cost of carry and refer to the rate that will be used to deliver a currency, bond or commodity at some future time.
Forecasts
and projections are based on current market conditions and are subject to change without notice. Projections should not be considered a guarantee.
For illustrative purposes only and does not reflect the performance of any Lord Abbett mutual fund or any particular investment.

 

What Could This Mean for Performance?
So this table is telling us that as of November 11, 2014, the market expects that two-year interest rates will rise by 159 basis points (bps) by November 2016, five-year rates by 99 bps, and 10-year rates by 59 bps. These seem like significantly big moves. But what would such increases actually mean for performance?

Let’s break it down, year by year. If we look at the forward rates for each swap for the one- and two-year periods, and use the timeframe of the swap rates depicted in the first column as a rough equivalent of duration, the “duration drag,” or negative effect on total return from the expected changes in interest rates for year one, would be:

  • Two-year duration strategy: 85 bps * 2 years = 1.70%

  • Five-year duration strategy: 56 bps * 5 years = 2.80%

  • 10-year duration strategy: 33 bps * 10 years = 3.30%

How could this play out in some fixed-income portfolios? Let’s look at two hypothetical instances: a shorter-duration (two-year) strategy yielding 2.5% and an intermediate-duration (five-year) strategy yielding 3.00%.Those numbers suggest that a portfolio that simply holds those securities, with no additional value generated through active management, will still experience positive returns even amid a bond-market selloff that produces a significant rise in bond yields. The shorter-duration strategy that starts with a yield of 2.5% would return, in this case, 2.5% - 1.7%, or 0.80% (80 bps). Meanwhile, the intermediate-duration strategy, with a starting yield of 3.0%, would return 3.0% - 2.8%, or 0.2% (20 bps). And the following year, with maturing securities reinvested at the new, higher yields indicated by the forward rates (85 bps and 56 bps higher), and accounting for the duration drag indicated by the one- and two-year yield differential,  we get:

  • Shorter duration: 2.50% + 0.85% - duration drag of 1.48% (74 bps * 2 yrs.) = 1.89% return

  • Intermediate duration: 3.00% + 0.56% - duration drag of 2.15% (43 bps * 5 yrs.) = 1.41% return

Summing Up
So, even if the bond market sells off in line with expectations of Fed hikes and higher rates, the performance of either strategy would still be positive. That positive return profile looks better than cash (yields of retail money market funds are currently near zero), and a whole lot better than being short or underweight the market and paying the yields on the two hypothetical strategies. And that’s not to mention the fact that these kinds of strategies can provide important diversification benefits for more equity-sensitive portfolios, as we have seen again this year with bond funds outperforming during equity market selloffs. 

Therefore, while these are rough numbers, they help to frame what a selloff could look like for two sample fixed-income strategies. And those numbers are purely portfolio yield minus duration, without including the potential benefit from reinvested coupon or from any potential price appreciation that could be derived from active management. As much as the market frets about the timing and degree of Fed rate hikes, the impact on fixed-income strategies may not be as bad as feared, as long as investors start with sufficient yield in the first place.

[Note: The above examples are provided for illustrative purposes only and do not reflect the performance of any Lord Abbett mutual fund or any particular investment. Forecasts and projections are based on current market conditions and are subject to change without notice. Projections should not be considered a guarantee.]

 

SIDEBAR
Interest Rates: The Way Forward

forward rate is the fair-value trade-off rate between a) sitting in cash and then investing in a fixed-maturity bond at a future date, or b) owning a single security for that same amount of time. For example, let’s say that an investor had a six-year investment horizon. He or she could simply buy a six-year security. In a year, it will be a five-year security, and the investor will have earned one year of interest, with five more years to follow. Or, the investor could buy a one-year Treasury note, and when that matures, purchase a five-year security. In order for that to make sense, the future five-year investment rate would have to be higher than the yield on the six-year bond in order to compensate for a year of less income (that’s especially relevant now, with yields on one-year Treasuries near historical lows). 

Now, there’s no way to know for sure where that five-year rate will be a year from now. But based on the difference in yields between the six-year security and where one could invest for only one year, there is a rate at which those two strategies would have equivalent returns: the forward rate. Because markets are quite efficient, those forward rates can be fairly good prognosticators of future yields. If nothing else, we can say that this represents the efficient market’s prediction about where rates will be at a given point in the future. 

Forward rates have done a good job in predicting selloffs in advance of prior rate hikes by the Federal Reserve and also in anticipating how key fixed-income strategies might have performed. The last two major Fed-hiking cycles were in 2004 and 1994. We believe that 2004 likely represents a better comparison, as the Fed’s policy transparency was similar to what we see today, and the fed funds rate was also being increased from historically low levels. (The 1994 episode, however, serves as a reminder of just how violently the bond market can sell off.)

What happened in 2004? Starting in June of that year, the Fed hiked the fed funds rate by 25 bps at every single Federal Open Market Committee (FOMC) meeting until June 2006. The fed funds rate had been at a then historical low of 1% for a year before the Fed began to tighten in 2004. The fed funds rate ended the tightening cycle at 5.25%.

For context, at the time, spot rates in the swap market for maturities of two, five, and 10 years were 2.64%, 3.87%, and 4.74%, respectively. Two-year forward rates in June 2014 for the two-, five-, and 10-year maturities (i.e., what the market implied rates would be in June 2006) were 5.11%, 5.63%, and 6.03%, respectively. By June 2006, the actual rates were 5.19%, 5.19%, and 5.20%. So, while the market’s expectation of higher rates for the five- and 10-year maturities overshot the end result, the two-year number was remarkably accurate.

For context, here is the performance of two widely followed fixed-income benchmarks, the Barclays U.S. Aggregate Bond Index and the Barclays U.S. Universal Bond Index, during those rate-hike episodes:

 

Source: Bloomberg.
*Annualized return.
Past performance is no guarantee of future results. Indexes are unmanaged, do not reflect the deduction of expenses, and are not available for direct investment.

 

Note that the market sold off significantly prior to the hikes, and the yield on the 10-year Treasury note dropped 10.3% from September 30, 1993–November 30, 1994, the largest bond-market selloff of the modern era. The Barclays Aggregate lost 3.5% during that period, while the Barclays Universal lost 2.51%.

 

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