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Fixed-Income Insights

Here are some approaches that may appeal to investors concerned about the potential for faster economic growth, higher interest rates, and a tougher trade policy. 

 

In Brief

  • The recent rise in U.S. interest rates, fueled in part by concerns about faster economic growth, inflation, and rate hikes by the U.S. Federal Reserve, has resulted in some volatility in U.S. fixed income markets.
  • But investors should be aware that not all bonds respond to rising rates in the same way.
  • Some fixed-income securities are interest-rate sensitive, and may experience significant price changes when rates move. One way to counteract such sensitivity in a portfolio is through holding shorter-maturity securities.
  • Another way to reduce rate sensitivity is to focus on more economically sensitive securities, such as corporate credits. These securities historically have benefited from improving economic conditions.
  • The key takeaway—Using one or a combination of bond sectors such as short corporates, high yield, or floating rate may help investors address Fed policy concerns, while allowing some flexibility for an investor’s risk tolerance.

 

The rise in interest rates since the U.S. presidential election on November 8, 2016, has many investors concerned about the bond portion of their portfolios. As rates rise in anticipation of stronger U.S. economic growth, higher inflation, and more aggressive policy from the U.S. Federal Reserve (Fed), it is helpful to know that not all bonds respond to rising rates in the same way. 

By knowing that some types of debt are highly sensitive to changes in interest rates, while other securities respond more to the economic environment, investors can construct a portfolio that addresses their fears as well as their tolerance for risk.

Interest-Rate Sensitivity
The 10-year U.S. Treasury note is often used as a benchmark for movements in U.S. interest rates. The 10-year U.S. Treasury is highly rate sensitive, which is a good thing if yields are falling, but not so good if yields are rising. From the November 8 to December 19, 2016,  the 10-year U.S. Treasury yield rose by 73 basis points (bps), from 1.83% to 2.56%; the concomitant fall in price for the 10-year note resulted in a total negative return of -6.55% for the period, according to Bloomberg. 

One way to reduce sensitivity in a portfolio is through holding shorter-maturity securities. In the same post-election period, the two-year U.S. Treasury note rose by 39 bps in yield, from 0.86% to 1.25%, leading to a return of -0.58%, noticeably better than the -6.55% loss on the 10-year U.S. Treasury note. Reducing rate sensitivity by reducing maturity is a well-known and successful strategy for rising rate environments.  

Credit Sensitivity
Another way to reduce rate sensitivity to changes in interest rates is to focus on more economically sensitive securities, such as corporate credits. Lower credit-quality corporate bonds, or high-yield securities, are a noteworthy example. Because companies in the lower-quality segment typically perform better in a stronger economy—and, therefore, experience reduced default risk in such an environment, even if it results in higher interest rates—they may offer relatively attractive performance. During the previously cited period since the November 8, 2016, U.S. election to December 19, 2016, the BofA Merrill Lynch U.S. High Yield Constrained Index actually rose in price, and offered a total return of 1.28%. 

Combining shorter-maturity issues with securities that are more economically sensitive, exemplified by short-term corporate bonds or bank loans, may offer the opportunity for attractive yield with reduced risk.  This combination may represent an appealing fixed-income alternative to longer term, high-quality bonds in a rising rate environment.    

Historical Performance During Periods of Rising Rates …
The simple tactics of shorter maturities and greater credit risk (or economic sensitivity) demonstrate their relative historical success in rising rate environments, as can be seen in Table I.  

 

Table 1. Short-Duration and Credit-Sensitive Securities Historically Have Performed Well in Periods of Rising Long-Term U.S. Treasury Yields
Index returns during periods of greater than 100 basis-point rise in the 10-year U.S. Treasury yield (month-end returns, except 2016)

Source: Morningstar.
1BofA Merrill Lynch Current 2-Year Treasury index.
2 Citigroup 10-Year U.S. Treasury Bond Index.
3 Bloomberg Barclays U.S. Aggregate Bond Index.
4 BofA Merrill Lynch 1-3 Year BBB-Rated Corporate Bond Index.
5 BofA Merrill Lynch High Yield Master II Constrained Index.
6 Credit Suisse Leveraged Loan Index.
Past performance is no guarantee of future results.  Performance during other time periods may have been different or negative.  Other indexes may not have performed in the same manner under similar conditions.  Indexes are unmanaged, do not reflect the deduction of fees and expenses, and are not available for direct investment.  For illustrative purposes only and does not represent the performance of any specific portfolio managed by Lord Abbett or any particular investment. 

 

Table 1 compares the returns of the 10-year U.S. Treasury note and another broadly used benchmark, the Bloomberg Barclays U.S. Aggregate Bond Index (BB Aggregate), with several bond alternatives with characteristics of shorter maturities, greater credit sensitivity, or a combination of both. Those securities with less rate sensitivity through shorter maturity and/or greater credit risk consistently outperformed the generally negative returns of the longer-dated, high-quality Treasury and BB Aggregate alternatives. Short-term corporate debt, high-yield bonds, and floating-rate loans delivered positive returns in every period.   

The most recent period of rising rates in late 2016 echoes the performance of previous instances. Investors seeking alternatives to traditional high-quality, longer-term bonds might consider categories such as short-term corporates, high-yield bonds, and floating-rate loans if they fear pro-growth fiscal initiatives could produce a rising rate environment similar to what we have seen in previous periods. Such sectors can be combined to craft an appropriate bond strategy that addresses concerns about rising rates—and properly reflects an investor’s risk tolerance.

… and Fed Rate Hikes
As with the periods of rising U.S. Treasury yields cited above, short-term corporates, high-yield bonds, and floating-rate loans also performed relatively well during times when the Fed was raising the fed funds rate.  Table 2 shows performance of these categories relative to that of the 10-year U.S. Treasury note and the BB Aggregate benchmarks during the last 30 years when the Fed was raising the benchmark U.S. interest rate. 

 

Table 2. Short-Duration and Credit-Sensitive Securities Historically Have Performed Well in Periods of Rising Fed Funds Rates
Index returns during periods of rising fed funds rates (month-end returns)

Source: Morningstar.
1BofA Merrill Lynch Current 2-Year Treasury index.
2 Citigroup 10-Year U.S. Treasury Bond Index.
3 Bloomberg Barclays U.S. Aggregate Bond Index.
4 BofA Merrill Lynch 1-3 Year BBB-Rated Corporate Bond Index.
5 BofA Merrill Lynch High Yield Master II Constrained Index.
6 Credit Suisse Leveraged Loan Index.
*Predates inception of index (January 1992).
Past performance is no guarantee of future results.  Performance during other time periods may have been different or negative.  Other indexes may not have performed in the same manner under similar conditions.  Indexes are unmanaged, do not reflect the deduction of fees and expenses, and are not available for direct investment.  For illustrative purposes only and does not represent the performance of any specific portfolio managed by Lord Abbett or any particular investment. 

 

Investors may conclude that since the Fed’s December announcement that policymakers expected to raise rates three times in 2017, combined with potential fiscal stimulus that could allow that intention to become a reality, some exposure to bond segments that historically have proven themselves in such an environment may be justified. Again, using one or a combination of bond sectors such as short corporates, high yield, or floating rate may help investors address a new Fed rate-hike regime, while allowing some flexibility for an investor’s risk tolerance.

Other Concerns
Rising interest rates seems to be the top worry among fixed-income investors, given expectations of U.S. government policies from the incoming Trump administration addressing increased infrastructure spending, tax reform, and reduced regulation. However, the prospect of increased protectionism in the United States through more restrictive immigration policy or a tougher stance on trade entails a different kind of risk. Protectionist policies, if pursued aggressively, could invite reciprocity from other countries, reduce trade, and potentially weigh on U.S. economic growth. In such an environment, higher-quality securities may attract renewed investor favor and economically sensitive debt could underperform. 

An important consideration for investors, therefore, may be strategic diversification within a bond portfolio. Such an approach may be appropriate to guard against the unlikely, but nonetheless concerning, possibility of a significant trade war between the United States and major trading partners such as Mexico and China. The appropriate balance among rate-sensitive and credit-sensitive fixed-income securities can reflect an investor’s expectation of successful pro-growth policies balanced with the likelihood of economic consequences of protectionist policies. 

The variety of rate-sensitive and credit-sensitive characteristics represented by different fixed-income asset classes allows investors to design a bond strategy that balances their fears of Washington policy consequences with their tolerance for portfolio risk.  

 

ABOUT THE AUTHOR

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