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Fixed-Income Insights

The third part of our series on the implications of possible interest-rate increases by the U.S. Federal Reserve examines the potential impact on U.S. short-term corporate securities.

 

In Brief

  • The U.S. Federal Reserve may begin hiking interest rates as early as June 2015. This has raised questions about the potential impact on various categories of fixed-income, especially regarding their price sensitivity to interest-rate changes.
  • What does history show us? Two-year U.S. Treasury securities, with less price sensitivity to interest rate changes, outperformed longer-duration 10-year Treasuries in each of the past five rate-hike cycles.
  • However, another short-duration asset class did even better. An index of one- to three-year investment-grade corporate securities handily outperformed both classes of U.S. Treasury securities in each of those intervals.
  • The key takeaway—Adding short-duration securities to a portfolio historically has been an effective strategy during past rate-hike periods. Investors who prefer a more conservative approach may find short-duration securities with investment-grade credit ratings a suitable choice. 

 

While it seems that investors have been fearful of higher interest rates for quite some time now, the reality of rising short-term rates is controlled by the U.S. Federal Reserve. And the increasing likelihood of an interest-rate “liftoff”—which Fed policymakers have been signaling for months—may soon be obvious to all. Seven of the Fed’s 17 members have expressed interest in having the option to hike rates at the meeting of the policy-setting Federal Open Market Committee (FOMC) on June 16–17, or have pushed for an earlier rate increase. 

To have the option to raise rates in June, the Fed may have to modify or eliminate the use of “patient” to describe its approach to the timing of policy changes in the communique following the FOMC meeting on March 17–18. This is because Fed chairwoman Janet Yellen has defined “patient” as waiting at least two more meetings before considering a rate hike. The Fed has only two meetings (another one is scheduled for April 28–29) before June. For the central bank to give itself the latitude to consider a rate hike in June, it needs to send a clear signal (at least by Fed standards) in March. 

Even if the Fed decides not to raise rates until September or later, for policymakers to have the option in June suggests elimination of “patient” in March—and the possibility of a significant market reaction at that time. Even if the Fed decides to wait before changing its policy language, now may be the time to fine-tune fixed-income strategies for a rising interest rate-environment that may start before the Fed makes its first move.

Trying Times for Longer Maturities
We recently examined the impact of Fed rate hikes on high-yield securities and bank loans. These economically sensitive investments have performed relatively well in past Fed-tightening cycles. However, some diversification away from economic sensitivity may be appropriate. Longer-term, high-quality fixed income generally offers good diversification to equity volatility in a portfolio. Understandably, though, the relatively poor performance during Fed tightening cycles may make a large allocation unappealing, given the Fed’s current intentions.

Table 1 illustrates the relatively poor performance of the 10-year U.S. Treasury Index during periods of Fed rate hikes. Performance was negative in three out of the five recent cycles, and averaged -1.87% during these periods.

 

Table 1. Short-Term Corporate Securities Historically Have Performed Well During Previous Fed-Tightening Cycles
Total return by index during indicated periods of Federal Reserve rate hikes

Source: Federal Reserve Bank of New York, Citigroup, BofA Merrill Lynch. Two-Year U.S. Treasury = Citi Treasury Benchmark 2-Year Index. 10-Year U.S. Treasury = Citi Treasury Benchmark 2-Year Index. 1-3 Year Corporates= The BofA Merrill Lynch 1-3 year U.S. Corporate Index.
Past performance is no guarantee of future results. The historical data are for illustrative purposes only, do not represent the performance of any Lord Abbett mutual fund or any particular investment, and are not intended to predict or depict future results. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment. Due to market volatility, the market may not perform in a similar manner in the future.
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. 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.

 

Shorter Maturity: Bigger Yield Change, but Positive Performance
On the other hand, shorter-maturity corporate bonds put in a markedly better performance during these times, despite the fact that in every cycle, except 1986–87, two-year Treasuries rose substantially more in yield than did 10-year Treasuries. The lower duration, or price responsiveness to interest-rate changes, of the two-year U.S. Treasury index allowed a positive return in every cycle and an average return during these periods of 2.41%, far better than the -1.87% average for the 10-year U.S. Treasury Index.

Adding short-duration securities to a portfolio historically has been an effective fixed-income strategy during past rate-hike intervals, without the lower-quality credit exposure of high-yield securities or bank loans. Even though lower-quality credit has performed relatively well in rising rate environments, some investors may not want to take on additional risk, or may wish to diversify their defensive strategies.

A “best of both worlds” solution may be to consider short-duration securities with investment-grade credit risk. Table 1 shows that an index of investment-grade corporate securities with maturities of one to three  years offers that combination. This category has succeeded in outperforming the two-year U.S. Treasury index in every one of the past five Fed-tightening cycles. The 3.29% average return of the one- to three-year corporate index compares favorably to the 2.41% average return for the two-year U.S. Treasury index over these periods.

A Different Approach to Short Duration
As Steve Hillebrecht explained in a previous commentary, Lord Abbett takes a different approach to investing in short-duration securities. The Short Duration Income Fund was designed to take advantage of inefficiencies across credit-sensitive sectors of the short-duration market. Sectors such as short-term investment-grade corporate bonds, for example, tend to offer additional yield over Treasuries, and historically have generated higher total returns over time. The Fund is diversified across multiple sectors of the market, and can adjust the allocations depending upon the market environment. Given this approach, the Fund historically has had a similar duration to a two-year Treasury bond, while generating much higher income.

In addition, one of the benefits of a short-maturity strategy is the constant cash flow that is being returned to reinvest at potentially higher rates. For example, as of February 27, 2015, approximately 24% of the Short Duration Income Fund was set to mature in less than one year. If market rates move higher, these maturing funds will be available to invest at those higher yields.

Selecting the Right Strategy
Whether the Fed decides to tighten as early as June, or as late as December, market anticipation of rate hikes suggests that some fine-tuning of fixed-income portfolios now may be appropriate. Regardless of an investor’s appetite for risk, there seems to be a variety of investment strategies that historically have worked well. Investors may prefer a strategy that focuses on economic sensitivity, such as high-yield or bank loans, which is an approach that can reduce interest-rate risk, or short-duration securities, or a combination of both. Given the Fed’s apparently dwindling policy “patience,” it is reassuring to know that there are fixed-income choices that have provided positive, relatively attractive return during periods of rising rates.

 

What Happens When The Fed Finally Hikes Rates?

How might various investments react after the Federal Reserve starts raising interest rates? In this series, Zane Brown looks at the potential impact on:

▪ High Yield
▪ Bank Loans
▪ Short Duration
▪ Equities

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