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Market View

Which types of taxable bonds historically have fared best in rising interest-rate environments?

As we approach yearend, investors may be taking a fresh look at their fixed-income allocations. Once again, a common question of the last several years is on their minds: what will happen to my bonds when interest rates go up?

This was a prevalent concern a year ago when rates spiked after the U.S. presidential election. In the closing days of 2017, that concern is resurfacing, as signs of stronger U.S. economic growth—with the potential for a further boost from changes to the U.S. tax code—have some market observers calling for higher rates. Indeed, the yield on the 10-year U.S. Treasury note is now approaching 2.5%, according to Bloomberg data, up over 40 basis points (bps) from recent lows in early September.

We think it’s helpful to frame the discussion of the impact of rising rates in terms of the type of rates we’re talking about (short-term versus long term) as well as the specific categories of bonds that investors may own. We believe there are two key questions at the heart of this discussion. Should bond investors focus on moves in longer-term rates, which have a greater impact on the broader bond market? Or should they be watching changes in the overnight rates directly controlled by the U.S. Federal Reserve (Fed)—namely, the fed funds rate--which have a more pronounced effect on short-term bonds? Here, we’ll examine both scenarios. As we have illustrated previously, not all bonds respond in the same way to rising rates.

Long-Term Rates
What types of fixed-income investments historically have done well during periods of rising long-term Treasury yields?  While it has often been said that there has been a 30-year bull market in bonds, a period marked by a long, general decline in interest rates, there have been several episodes of significant increases in yields on U.S. government bonds within that period. Many Market View readers will be familiar with Table 1, which illustrates the performance of various bond categories during the last eight periods when the yield on the 10-year Treasury rose by 100 bps or more.

 

Table 1. Historically, Lower-Duration, Credit-Sensitive Bonds Have Performed Well in Periods of Rising Long-Term U.S. Treasury Yields
Index returns during periods of increases greater than 100 basis points in the 10-year U.S. Treasury yield (month-end annualized returns)

Source: Morningstar.
1FTSE 10-Year Treasury Bond Index. 2Bloomberg Barclays U.S. Aggregate Bond Index. 3Bloomberg Barclays U.S. Floating Rate Note Index. 4ICE BofAML U.S. Corporate BBB-Rated 1-3 Year Index. 5Credit Suisse Leveraged Loan Index. 6ICE BofAML U.S. High Yield Master II Constrained Index. 7ICE BofAML Global High Yield Index. 8 ICE BofAML U.S. Convertible Index. 9S&P 500® Index.
Past performance is no guarantee of future results. Performance during other time periods may have been different or negative. 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 shows that as long-term rates rise, longer-duration government-related securities tend to suffer the most. Each of these periods led to negative returns for the 10-year Treasury note, as higher yields translated to lower prices, with an average loss of 7.3% during these eight periods. It should come as no surprise that the Bloomberg Barclays U.S. Aggregate Bond Index, which now has an effective duration of 6.0 years and is largely comprised of U.S. Treasuries and government-related securities, also generated losses in seven of these eight periods.

Which asset classes historically have done well during periods of rising long-term Treasury yields? Lower-duration and more credit-sensitive bonds: for example, short-term corporate bonds, high-yield corporate bonds, and floating-rate bank loans posted positive returns in all eight periods. Stocks were positive in every period, while convertible bonds were positive in all periods but one.

What might lie behind this performance? As we have pointed out before, higher Treasury rates often coincide with an improving economy, which may lead to a rise in corporate earnings, better credit fundamentals, and increasing investor appetite to take on risk, resulting in declining credit spreads. That spread compression, along with the higher income generated by these securities, can help offset the move higher in Treasury rates. 

Short-term corporate bonds feature far lower duration than longer maturity securities. As a result, short-term bond prices are relatively stable during periods of volatility in interest rates (or in credit spreads). 

With that in mind, what might fixed-income investors do to protect against the risk of the potential for further increases in long-term interest rates?

  • They might consider adding equity-related and credit-sensitive fixed-income sectors (high-yield, bank loans, convertible bonds); or
  • Those who prefer investment-grade strategies may want to reduce the duration of their portfolio via short- or ultra short-term fixed-income strategies.

Short-Term Rates
Let’s move on to our second interest-rate question: What happens when the Fed raises short-term rates?  In past discussions on the data in Table 1, specifically about the performance of short-term corporate bonds, we have heard concerns about how short-term bonds may perform during periods when the Fed is hiking the fed funds rate. Many investors assume that when the Fed raises short-term rates and the yield curve flattens, shorter-maturity securities will suffer.

Here, again, a look at recent market history may be in order. How have various segments of the bond market performed during periods rising short-term rates spurred by Fed tightening? Table 2 summarizes the performance of various asset classes during the last six cycles of Fed tightening, including the current instance.

 

Table 2. Short Credit and Floating-Rate Bonds Historically Have Performed Well When the Fed Tightens
Index returns during periods of rising fed funds rates (month-end returns)

Source: Morningstar.
1Bloomberg Barclays U.S. Aggregate Bond Index. 2FTSE Two-Year Treasury Benchmark (On-the-Run) Index. 3FTSE 10-Year Treasury Bond Index. 4ICE BofAML U.S. Corporate BBB-Rated 1-3 Year Index. 5Bloomberg Barclays 1-3.5 Year CMBS Index. 6ICE BofAML ABS Fixed Rate 0-3 Year Index. 7Bloomberg Barclays U.S. Floating Rate Note Index. 8Credit 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.

 

Why might short-maturity bonds remain positive even as the Fed pushes short rates higher? The common fear is that Fed tightening will lead to a flattening of the yield curve, and short-maturity bonds will suffer negative returns. While short-term yields do tend to rise more than long-term yields during Fed tightening cycles, you have to look at the impact on performance: since they are shorter in duration, the move in yield has a more muted impact on prices of short-maturity bonds. The income generated, therefore, is a large component of total return.

As a result, two-year U.S. Treasury bonds have generated positive returns in each of these six periods. But the most compelling performance story during Fed tightening cycles is found in the other asset classes detailed in Table 2:

  • Short-term corporate bonds had positive returns in every period, well ahead of those for both the two- and 10-year Treasuries. Why? Curve flattening means short-term rates go up, but due to the securities’ low duration, prices do not move much. Here, higher income translates into higher total return.
  • Short-term commercial mortgage-backed securities (CMBS) and asset-backed securities (ABS) posted similar results to short-term corporates, though the representative indexes have shorter histories.
  • Securities with floating-rate coupons don’t have duration, so their prices experience virtually no impact from rising rates. They actually benefit from higher rates, as their coupons adjust upward.  Historically, bank loans have been one of the best asset classes to own during Fed tightening cycles. 
  • For those who find floating-rate appealing, but prefer investment-grade securities, floating rate notes may merit consideration. These securities, which are investment-grade corporate bonds with floating coupons, can play a key role in ultra-short duration strategies.

We have seen this play out during as the Fed’s current rate-hike regime. On December 13, the Fed raised rates for the third time in 2017--the fifth hike in the past two years. The yield curve has flattened as the yield on the two-year Treasury has increased by 150 bps (see Chart 1), while the 10-year Treasury yield has been range bound. But over the past two years, short-term corporate bonds, CMBS, ABS, floating rate notes, and bank loans have all generated positive returns. 

 

Chart 1. Short Rates Have Increased Significantly More than Long Rates 
Yield (in percent; target rate on fed funds) on indicated benchmarks, September 30, 2015–November 30, 2017

Source: Bloomberg data for U.S. Treasury securities and LIBOR; U.S. Federal Reserve for fed funds rate.
Performance quoted above is historical. Past performance is not a reliable indicator or guarantee of future results. The historical data are for illustrative purposes only, do not represent the performance of any specific portfolio managed by Lord Abbett or any particular investment, and are not intended to predict or depict future results.

 

As rates have been moving higher, short-maturity strategies have the benefit of regular cash flows from coupon payments, which can be re-invested at prevailing higher rates. Thus, reinvested or new funds placed in short-maturity securities will be starting at a higher initial yield, creating the potential for higher income in the future. 

Summing Up
We have long cautioned about the difficulty of accurately predicting moves in interest rates. However, if history is any guide, if we continue to see a move to higher U.S. Treasury yields, we would expect that short-duration bonds, high-yield bonds, and floating-rate loans would have the potential to outperform core bonds. Of course, a reversal in the trajectory of U.S. economic growth, or some other “risk-off” market event, may favor high-quality core bonds.

The best approach to the current environment may be a diversified portfolio, one that includes allocations to high-quality core bonds, short-duration bonds, high-yield bonds, and bank loans. Alternatively, investors could turn to a multi-sector strategy that gives the manager the flexibility to invest across investment-grade, high-yield, and equity-related securities in order to position the portfolio most appropriately for the given economic environment.

 

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