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Fixed-Income Insights

The current interest-rate environment makes choosing the fixed-income components of retirement portfolios a bit tricky. Where might your best options lie?

 

In Brief

  • For investors building a retirement portfolio, the current low-yield environment means that there are fewer investment options that can keep pace with even today’s low level of inflation.
  • Thus, investors have been forced to consider taking greater degrees of credit risk and maturity risk. Here, we examine the yields—and associated risks—of different domestic income alternatives.
  • We looked at key factors influencing fixed-income securities, including duration (or an investment’s price sensitivity to changes in interest rates), credit risk, and changes in the economic environment.
  • The key takeaway: Familiarity with the performance characteristics of asset classes in light of the risk factors described above should enable a more effective retirement portfolio design.

 

These are frustrating times for income-seeking investors—including those who are building retirement portfolios. The current low-yield environment means that there are fewer investment options that can keep pace with even today’s low level of inflation. The U.S. Federal Reserve’s (Fed) go-slow approach to rate normalization offers little prospect of substantially higher short-term rates soon. And if rates are low in the United States, they’re even worse elsewhere. Negative interest rates in many other developed economies have prompted global investors to look to U.S. markets for positive-yielding alternatives, pushing U.S. yields lower as a result. 

The income question is especially pressing for U.S. investors searching for retirement income. They have been forced to consider taking greater degrees of credit risk, maturity risk, and possibly leverage in order to capture yields only marginally greater than long-term inflation expectations of 2% (based on the Fed’s stated target). 

What, then, should retirement-focused U.S. investors be thinking about now? We believe that this examination of the yields—and associated risks—of different domestic alternatives should provide perspective and a framework for deciding which options best suit an investor’s income objective and risk tolerance. 

Duration Risk and the Go-Slow Fed
The prospect of a very slow pace of rate hikes from the Fed seems likely to keep short-term interest rates extraordinarily low over 2016 and 2017. This means that short-term investments are not likely to adjust higher in yield, and, therefore, will fall short as an income solution. As important, though, a slower rate-hike cycle also may mean that intermediate- and longer-term investments will experience less of a negative impact than if the Fed were more aggressive. 

If intermediate- and longer-term investments are less affected, investors may feel more comfortable with some maturity risk. But while they may suffer less by investing in shorter-term instruments, they may still experience negative returns. How can investors avoid that outcome? It will be important to examine the duration, or price responsiveness of an investment to changes in interest rates, relative to the yield or income of that investment. 

Table 1 illustrates this strategy by comparing the potential impact of rate hikes on two investments with similar yield but disparate durations. Using May 31, 2016, characteristics for a 10-year U.S. Treasury index and a one- to three-year U.S. corporate bond index, one-year returns have been calculated for interest-rate increases of 0.25%, 0.50%, and 0.75%, respectively, taking into account the respective durations of 9.27 on the 10-year U.S. Treasury index and 1.93 on the one- to three-year U.S. corporate bond index. With current yields on the two indexes very similar, at 1.80% and 1.83%, the one- to three-year corporate index, with a far lower duration, outperforms in each of the rate-rise scenarios. [Projections are based on current market conditions and should not be considered a guarantee.]

 

Table 1. Return Comparisons: Short-Term Corporate Bonds versus 10-Year Treasuries

Source: BofA Merrill Lynch and Lord Abbett. Yield to maturity and modified duration data as of May 31, 2016. The scenario detailed in Table 1 analyzes potential performance over one year beginning May 31, 2016, with yields on indicated indexes starting at the same level as they were on May 31, 2016, based on U.S. Federal Reserve interest-rate increases of 0.25%, 0.50%, and 0.75%, respectively, by May 31, 2017. The projected performance is then adjusted by the indicated duration for the indexes as of May 31, 2016. 

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 portfolio managed by Lord Abbett or any particular investment.
Indexes are unmanaged and are not available for direct investment.

 

It is reasonable to expect that the yield curve would flatten as the Fed hikes rates, but even that assumption does little to overcome the duration difference. If the one- to three-year corporate index rose 0.50%, the 10-year U.S. Treasury index may rise only by 0.25%. In such a scenario, the shorter-duration one- to three-year corporate index would post a positive return of 0.84%, versus a negative return on 0.49% for the 10-year Treasury index—an outperformance of 1.33%. Even if the one- to three-year corporate index rose 0.75% and the 10-year U.S Treasury index rose only 0.25%, the shorter index would outperform. 

Thus, even at a very constrained pace of rising rates, higher-duration bonds may provide disappointing returns, especially if the yield is too low to offset the negative price movement. Maintaining yield close to, or even above, duration may be a useful guide for investors in a rising rate environment. However, the one- to three-year corporate index comes with another risk: credit risk. Even though the underlying securities are investment grade, there is still more risk than exists with government issuers. Consider, though, that the economic growth that allows rates to rise also may allow companies to perform well.

Credit Risk, Rising Rates, and Economic Growth
If rising interest rates imply faster economic growth, investors may have more comfort with credit risk in a rising rate environment. Indeed, previously published Lord Abbett research has shown that high-yield bonds performed relatively well during the five Fed rate-hike cycles over the past 30 years. An index of high-yield securities outperformed the broad bond-market benchmark Barclays U.S. Aggregate Bond Index (Barclays Aggregate) in four out of those five cycles, and the relationship of yield to duration helps explain why. 

Table 2 compares the theoretical return of the high-yield benchmark Credit Suisse High Yield Index with that of the Barclays Aggregate if rates rise 0.25%, 0.50% and 0.75%. Using May 31, 2016, index characteristics, the high yield index outperforms in every scenario. Once again, the yield-to-duration ratio is useful in assessing performance characteristics in a rising rate environment, even if rates rise modestly.

 

Table 2. Return Comparisons: High-Yield Bonds versus Core Bonds

Source: Credit Suisse, Barclays, and Lord Abbett. Yield to worst and modified duration data are as of May 31, 2016. The scenario detailed in Table 2 analyzes potential performance over one year, beginning May 31, 2016, with yields on indicated indexes starting at the same level as they were on May 31, 2016, based on U.S. Federal Reserve interest-rate increases  of 0.25%, 0.50%, and 0.75%, respectively, by May 31, 2017. The projected performance is then adjusted by the indicated duration for the indexes as of May 31, 2016. 

*Assumes 4% defaults with 40% recovery.
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 portfolio managed by Lord Abbett or any particular investment.
Indexes are unmanaged and are not available for direct investment.

 

In fact, the performance calculation may understate the true performance of high yield. The economic sensitivity of high-yield debt has at times enabled yields on high-yield bonds to decline, and prices to rise, during a period of generally rising rates on higher-quality debt. In addition, active management may avoid some of the return impairment resulting from the 4% default and 40% recovery rates for the 12-month period assumed in the table’s calculations. Downside risk is also present, however, so high-yield exposure needs to be monitored. A recession would lead to price declines on credit-sensitive debt at the same time that equities would also come under pressure.  

Other Considerations
If a rising-rate environment implies economic growth, and yield close to—or above—duration is a favorable characteristic when yields rise, then two other credit-sensitive investments deserve attention: bank loans and equities. Bank loans seem to provide the ultimate yield-to-duration ratio. Unlike most traditional bonds that pay a fixed coupon rate, bank loans typically pay an adjustable rate based on a spread above short-term interest rates such as three-month LIBOR, the London Interbank Offered Rate. This implies a duration of close to zero, as yields on most loans are set to adjust higher as short rates rise. Income is again a function of credit, but if rising rates are predicated on economic strength, and an investor is comfortable with additional credit risk, bank loans seem well-suited to a rising rate environment.

Equities, too, historically have performed well during rising rate cycles. With a recent dividend yield of around 2% on the benchmark S&P 500® Index, according to Bloomberg, equities can provide income at about the level of inflation and greater than that available on 10-year U.S. Treasury securities. Investors must be comfortable with the potential volatility but, as we have seen, fixed-income securities can be volatile as well. Thus when constructing a portfolio, income-conscious investors can benefit from a judicious equity allocation as well.

A Menu of Income Options
Table 3 offers simplified return calculations for a variety of investments. Performance differences suggest several considerations when searching for income, but also demand several caveats. 

 

Table 3. Return Comparisons: The Impact of Rising Rates

Source: BofA Merrill Lynch, Barclays, Credit Suisse, Bloomberg, and Lord Abbett. Yield and modified duration data are as of May 31, 2016. The scenario detailed in Table 3 analyzes potential performance over one year beginning May 31, 2016, with yields on indicated indexes starting at the same level as they were on May 31, 2016, based on U.S. Federal Reserve interest-rate increases of 0.25%, 0.50%, and 0.75%, respectively, by May 31, 2017. The projected performance is then adjusted by the indicated duration for the indexes as of May 31, 2016. 

1Assumes 3.2% defaults with 60% recovery.
2Assumes 4.0% defaults with 40% recovery.

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 portfolio managed by Lord Abbett or any particular investment.
Indexes are unmanaged and are not available for direct investment.

 

The trade-offs between income and volatility seem to favor credit risk over maturity risk in today’s environment. This is supported by above-average yield spreads among high yield, contrasted with a relatively flat yield curve. However, the importance of income must also be balanced with the total portfolio risk that includes consideration of economic risk, preservation of principle, and correlation of assets. Some familiarity with the performance characteristics of asset classes with credit risk and maturity risk should enable a retirement portfolio design that better reflects an investor’s income goals as well as total risk preferences.

 

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