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Investor frustration with the low yields offered by the classic "core" fixed-income strategy—i.e., government securities and high-quality corporate bonds—could be exacerbated by the heightened sensitivity of high-quality debt to interest-rate risk, as measured by duration, which is the change in the value of a fixed-income security that will result from a 1% change in market interest rates. (Duration is expressed as a number of years, and, generally, the larger a portfolio's duration, the greater the interest-rate risk or reward for underlying bond prices.) The difference between an investment's yield and duration could have a significant bearing on its potential price changes, income generation, and, therefore, cumulative total return.
The prospect of rising interest rates could spell trouble for fixed-income categories with high duration. One telling example of this is the Barclays U.S. Aggregate Bond Index, a widely used benchmark of U.S. investment-grade debt that reflects the classic core fixed-income strategy. The composition of the index, which is heavily skewed toward government-related securities, primarily Treasuries, agency mortgage-backed securities, and other agency debt, has contributed to this low yield/high duration profile. As Chart 1 shows, the Barclays U.S Aggregate Bond Index featured a paltry yield to maturity of 2.34%, as of October 10, coupled with a modified adjusted duration of 5.5 years—a 10-year high for the index. (See Chart 2.)
Past performance is no guarantee of future results.
1 "Other" refers to sovereign, supranational, and local authorities.
For illustrative purposes only and does not represent any specific Lord Abbett mutual fund or any particular investment.
Indexes are unmanaged, do not reflect the deduction of fees and expenses, and are not available for direct investment.
While the current low yield on high-quality debt securities is unappetizing, the implications of the high duration of this fixed-income category could be even worse. Why? It is widely expected that sometime in 2014, the Federal Reserve will begin to withdraw monetary accommodation from the economy by tapering bond purchases. A market environment with less Fed intervention could create a scenario wherein interest rates normalize over the course of five years, potentially resulting in a fed funds rate of 4%, which is the Fed's long-term projection.1
And that's where the high duration of the high-quality credit category embodied by the Barclays U.S. Aggregate Bond Index could create a big disadvantage for investors. The modified adjusted duration on the Barclays U.S. Aggregate Bond Index has risen sharply over the past five years, and has held above 5.0 years for much of the past 12 months. (See Chart 2.)
For illustrative purposes only and does not represent any specific Lord Abbett mutual fund or any particular investment. Past Performance is no guarantee of future results.
Indexes are unmanaged, do not reflect deduction of fees or expenses, and are not available for direct investment.
Here’s how the high duration and low yield could work against investors. The current modified adjusted duration of the Barclays U.S. Aggregate Bond Index, at 5.5 years, suggests that a 100 basis-point rise in interest rates would translate to a 5.5% decline in the underlying price of the index. [An investor cannot invest directly in an index.] This is a simple estimation with several assumptions, such as assuming a parallel shift in the yield curve and no change in credit spread. If this occurred over the course of a year, the 2.3% yield to maturity earned would result in a loss of roughly 3.2%.
The duration dilemma illustrates the tricky position of fixed-income investors in the current market environment. The traditional core bond holding may be in a precarious position—a low relative yield and high relative duration. Investors still require sufficient yield to support their income needs and provide a positive real return. Unfortunately, extending maturity too far along the yield curve will likely increase a bond portfolio's duration and expose investors to heightened interest-rate risk. What should investors do in such a situation? One approach would be to shift from interest-rate sensitive fixed-income categories toward more credit-sensitive segments. In a future Market View, we will take a closer look at the yield versus duration relationship of a number of fixed-income classes and the specific types that may make the most sense for investors seeking attractive income in the present, and lower duration if rates rise in the future.
1 "Economic Projections of Federal Reserve Board Members and Federal Reserve Bank Presidents, September 2013," Board of Governors of the Federal Reserve System, September 18, 2013.
A Note about Risk: The value of investments in fixed-income securities will change as interest rates fluctuate. As interest rates fall, the prices of debt securities tend to rise, and as interest rates rise, the prices of debt securities tend to fall. Bonds may also be subject to other types of risk, such as call, credit, liquidity, interest-rate, and general market risks. Longer term debt securities are usually more sensitive to interest rate changes. The longer the maturity date of a security, the greater the effect a change in interest rates is likely to have on its price. Lower-rated debt securities may involve greater risks than higher rated debt securities. Mortgage-backed securities are subject to pre-payment risk. No investing strategy can overcome all market volatility or guarantee future results.
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. Although U.S. government securities are guaranteed as to payments of interest and principal, their market prices are not guaranteed and will fluctuate in response to market movements.
Maturity is the period of time for which a financial instrument remains outstanding. Maturity refers to a finite time period at the end of which the financial instrument will cease to exist and the principal is repaid with interest. The term is most commonly used in the context of fixed income investments, such as bonds and deposits.
Modified adjusted duration can refer to both the weighted average of the time over which fixed interest payments are made and to the sensitivity of the bond's price to changes in interest rates. The latter is referred to as modified duration. Modified adjusted duration is modified duration adjusted to reflect put and/or call options on a bond.
Yield to maturity is the rate of return anticipated on a bond if held until the end of its lifetime.
A yield curve shows the relationship between yields and maturity dates for a set of similar bonds at a given point in time.
A basis point is one one-hundredth of a percentage point.
The Barclays U.S. Aggregate Bond Index is an unmanaged index composed of securities from the Barclays Government/Corporate Bond Index, Mortgage-Backed Securities Index and the Asset-Backed Securities Index. Total return comprises price appreciation/depreciation and income as a percentage of the original investment. Indexes are rebalanced monthly by market capitalization.
Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.
The opinions in Market View are as of the date of publication, are subject to change based on subsequent developments, and may not reflect the views of the firm as a whole. The material is not intended to be relied upon as a forecast, research, or investment advice, is not a recommendation or offer to buy or sell any securities or to adopt any investment strategy, and is not intended to predict or depict the performance of any investment. Readers should not assume that investments in companies, securities, sectors, and/or markets described were or will be profitable. Investing involves risk, including possible loss of principal. This document is prepared based on the information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy and completeness of the information. Investors should consult with a financial advisor prior to making an investment decision.