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Market View

Here, we revisit the question of how U.S. taxable bonds may fare in the face of rising interest rates.

In last week’s Market View, we looked at the performance of the municipal bond market during periods of U.S. Federal Reserve (Fed) rate hikes. We showed that not all Fed-tightening cycles are the same.  During certain periods when the Fed had raised rates in a slow and gradual manner, through a well-communicated strategy, long-term rates remained relatively stable, and long-term bonds performed well.

As a bond investor, it often is more important to consider moves in longer-term rates rather than changes in the overnight rates directly controlled by the Fed, namely the fed funds rate.  So, when investors ask about the impact of higher rates, our first response is often: Which rates are you talking about—fed funds, U.S. Treasury yields, or some other category?

Credit-sensitive and equity-related segments of the bond market have historically have generated positive returns during periods of rising Treasury yields.

In addition, history has shown that there can be a wide range of returns by U.S. fixed-income asset class, depending on the market environment. So, an equally important question surfaces: Which types of bonds do you own? This week, we will review the performance of various bond sectors during period of rising long-term rates, as measured by the (representative) 10-year U.S. Treasury note yield. 

The financial media often have characterized the past three decades as a “30-year bull market for bonds.” But as illustrated in Chart 1, which tracks the movement of the yield on the 10-year Treasury note, this bull market has not moved in a straight line.  While it generally has been an environment of declining interest rates, there have been eight separate periods when the 10-year Treasury yield has jumped by more than 100 basis points (bps) over a short period, most recently in the second half of 2016. 

 

Chart 1. U.S. Treasuries Have Posted Negative Returns When Yields Rose More Than 100 Basis Points
Return on 10-year U.S. Treasury securities during eight periods of greater than 100 basis-point increase in the 10-year U.S. Treasury yield, March 31, 1993–March 31, 2017

Source: Bloomberg and Morningstar.
Note: 10-year Treasury yield as represented by the Bloomberg Generic 10-Year United States Government Note. 10-year Treasury performance as represented by the Citigroup 10-Year Treasury Bond Index.
*Rise of 100 basis points must have occurred within a 16-month time period.
Past performance is no guarantee of future results. Performance during other periods may have been different.

 

Which Bonds Do You Own?
Table 1 summarizes the returns of various asset classes during these eight periods of rising Treasury yields.  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.

 

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 returns)

Source: Morningstar.
1Citigroup 10-Year Treasury Bond Index. 2Bloomberg Barclays U.S. Aggregate Bond Index. 3BofA Merrill Lynch U.S. Corporate BBB-Rated 1-3 Year Index. 4BofA Merrill Lynch High Yield Master II Constrained Index. 5Credit Suisse Leveraged Loan Index. 6Bloomberg Barclays U.S. Floating Rate Note Index. 7BofA Merrill Lynch U.S. Convertible Index. 8S&P 500® Index.
Past performance is no guarantee of future results. Performance during other time periods may have been different or negative.

 

However, different asset classes had very different experiences in these episodes: long-duration government-related securities suffered the most, while lower-duration and more credit-sensitive bonds historically performed well.  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, generated losses in seven of these eight periods.     

Moving down to lower-duration and lower-rated credit, you will see positive returns in short-term corporate bonds, high-yield corporate bonds, and floating-rate bank loans in all eight periods.  Looking at equity-related securities, stocks were positive in every period, while convertible bonds were positive in all periods but one.    

Why Has Credit Done Well When Rates Rise?
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 can help offset the move higher in Treasury rates.  Then if we look at specific asset classes, we find:

  • Short-term corporate bonds—Low duration leads to limited price movements in the face of rising rates. Additional yield spread over government-related securities provides higher income, while potential spread tightening can partially offset higher Treasury rates. 
  • High-yield corporate bonds—Although high-yield bonds may have an intermediate stated duration, they historically have had negative correlation with U.S. Treasury bonds. The effect of rising Treasury yields has often been offset by spread compression and high coupon income, leading to positive returns in periods of rising rates.
  • Floating-rate loans—Loans also benefit from an improvement in corporate credit associated with a strengthening economy. Since loans have coupons that adjust with short-term rates, typically every 90 days, they can benefit from a rise in the benchmark LIBOR (the London interbank offered rate, which typically moves in line with the fed funds rate). In addition, since loans do not have the duration exposure of typical fixed-rate bonds, prices are not affected by moves in long-term rates.

What Does Duration Tell Us?
When considering the interest-rate exposure of a fixed-income portfolio, many investors look at the portfolio’s effective duration.  As an example, following the simple math used to illustrate the concept, a portfolio with an effective duration of 5.0 years is expected to decline by approximately 5% for a 100 basis-point move in rates.  However, there are a few points to keep in mind:

  • A “100 basis-point move in rates” refers to a move in the yield to maturity on that bond or portfolio, not the overnight fed funds rate.
  • The decline of “approximately 5%” is the expected price decline, assuming that the 100 basis-point move in rates occurs immediately, and does not consider any income earned over time.
  • Duration is a mathematical calculation based on the timing of cash flows on a bond.   It does not, however, account for the negative correlation between rate moves and spread moves illustrated above.  In other words, this calculation does not adjust for the different behavior of a U.S. Treasury bond and a high-yield corporate bond that each may have a 5.0-year effective duration.

Duration alone does not give a good indication of interest rate sensitivity.

So, rather than simply focusing on the stated duration of a portfolio, it may be better to examine the interest-rate sensitivity of the portfolio.  The data in Table 1 provide evidence that effective duration alone does not give a good indication of true interest-rate sensitivity of credit-related bond sectors, and so is a poor indicator of how such bonds may perform during rising rate periods.

Another way to view these relationships is through correlation data. Chart 2 shows that ‘BBB’ rated corporate bonds and high-yield corporate bonds, both with intermediate effective durations, historically have had low or negative correlation with U.S. Treasuries. 

 

Chart 2. Which Bond Categories Have the Lowest Correlation with U.S. Treasuries?
Correlation with Bloomberg Barclays U.S. Government Bond Index, trailing 10 years as of March 30, 2017

Source: Morningstar.
1Bloomberg Barclays U.S. Government Bond Index. 2Bloomberg Barclays U.S. Aggregate Bond Index. 3Bloomberg Barclays U.S. Treasury U.S. TIPS Index. 4Bloomberg Barclays U.S. Corporate Baa-Rated Index. 5BofA Merrill Lynch U.S. Corporate BBB-Rated 1-3 Year Index. 6Bloomberg Barclays U.S. Floating Rate Note Index. 7Bloomberg Barclays U.S. Corporate High Yield Index. 8BofA Merrill Lynch U.S. Convertible Index. 9S&P 500® Index. 10Credit Suisse Leveraged Loan Index.
Past performance is no guarantee of future results. Correlation is a statistic that measures the degree of association between two variables.

 

Summing Up
If history is any guide, investors who are expecting a rising-rate environment may want to favor lower-duration assets.  But an investor may be better served by digging a little deeper—gaining a greater understanding of the true interest-rate sensitivity of his or her portfolio, which cannot be measured by duration alone.  

 

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