CAPTRUST Chief Investment Officer
Following a 30-plus-year bull market in the fixed income or bond market, the path forward is much more uncertain. While investors await the next move for fixed income, unless bond prices move higher (and, by definition, bond yields move lower), historically low interest rates indicate that bonds will offer lower total returns than most bond investors have experienced during recent periods.
May 2013 represented the worst monthly return for the bond market since the 2008 financial crisis, with the Barclays Capital Aggregate Bond Index (BarCap Agg) losing 1.78 percent. Fears that the U.S. Federal Reserve would soon begin to rein in its bond-buying program hurt fixed income in general. The 10-year Treasury yield rose from 1.64 percent on May 1 to 2.16 percent on June 1, which in percentage terms was the largest month-over-month increase in yield history. The 10-year Treasury continued its rise in June, reaching a high of 2.66 percent before closing the quarter at 2.48 percent. Many yield-sensitive asset classes and sectors fell in sympathy, including corporate bonds, municipal bonds, public real estate, utility stocks, and master limited partnerships. For the quarter, the BarCap Agg was down 2.32 percent. “All things yield” appeared vulnerable as government bond prices sold off and interest rates moved higher.
Where Will Interest Rates Go from Here?
Looking at Figure Two, one can see that since the summer of 2011, 10-year Treasury yields have been firmly below 3 percent. This is due to global central banks’ active suppression of interest rates through buying fixed income securities in the open market in an attempt to encourage lending and spark economic activity. However, the U.S. Federal Reserve has recently hinted that those open market purchases could begin to slow, leaving investors to question who will replace the Fed and buy bonds. This speculation led to the second quarter’s weak bond market returns.
Per Figure Two, it appears we are approaching interest rate levels that are halfway between the lows seen in the summer of 2012 and the higher levels seen before the summer of 2011. From here, rates can do one of three things: move lower, remain flat, or move higher.
Let’s Explore the Case for Each Scenario:
• Rates move lower
This scenario could happen for several reasons, most likely driven by economic weakness that causes the Fed and other central banks to continue their bond purchases. Sticky unemployment, a slowing China, continued European market malaise, and weaker equity and riskier asset classes could all cause this development. While this may seem implausible given where interest rates sit right now, we have seen them at even lower levels; the 10-year Treasury touched below 1.4 percent in July 2012, a full percentage point lower than today.
• Rates remain flat
A goldilocks economy — growing neither too fast nor too slow — where inflation remains tame (the Bureau of Labor Statistics notes that month-over-month change in the Consumer Price Index has fallen over the past two months) and employment and wage growth remain tepid could cause interest rates to hover at or near current levels.1
• Rates move higher
An economy showing resilience, the Fed backing off its recent bond purchase trend (or anticipation thereof), inflationary pressures, or asset allocation movement toward riskier asset classes or foreign bonds could all drive interest rates higher. As described earlier, rising prevailing interest rates tend to hurt bondholders.
Our base case scenario is for rates to rise, but to do so at a gradual pace over the next 18 to 24 months subject to numerous fits and starts depending on the economy’s health and central bank involvement. If we are wrong, we suspect it will be because a move higher happens faster than we expect — perhaps accelerated by investor overreaction to market news.
The Need to Gauge Speed
While higher interest rates could hurt bond investors, as Figure Three shows, rising yields do not always translate into bond investor losses. Two key variables will likely determine how acutely rising rates may impact bond investors: the magnitude of the rate increase and the speed at which rates increase. The higher rates move and the shorter the time period, the more painful the experience.
For example, from December 2008 through March 2010, the 10-year Treasury yield rose by almost 1.5 percentage points while the BarCap Agg returned more than 8.7 percent. This was the result of a modest rate increase (as a percent of the starting yield) and a timeframe long enough for coupon payments to outweigh the price decline. Also, because the BarCap Agg is a diversified index that includes corporate and mortgage bonds, some decoupling from government bonds may have occurred.
By contrast, in May, a mere 0.5 percentage-point increase in 10-year Treasury yields set the bond market back as coupons failed to offset falling bond prices over such a truncated period. In addition, since interest rates are very low, the starting yield did not provide much of a cushion against higher rates.
What Can Bond Investors Expect Moving Forward?
CAPTRUST research suggests that current interest rates often portend future returns. As Figure Four displays, the prevailing interest rate as measured by the 10-year Treasury provides a reasonable approximation of five-year forward annualized fixed income returns as measured by the BarCap Agg (note that forward returns starting in 2009 are for less than five years and are as of June 7, 2013). So, you would interpret the chart this way: in 1997, the 10-year Treasury started the year yielding 6.43 percent. During the period encompassing 1997–2002, the BarCap Agg delivered a 7.42 percent annualized return.
Over time, the correlation between the 10-year Treasury’s starting yield and five-year forward return has been over 0.9, a strong, positive relationship. Correlation cannot be higher than 1.0, and a correlation of 0.6 to 0.7 is considered high. Therefore, given the 10-year Treasury’s current low level, if the relationship described holds, investors should expect bond portfolios to deliver lower nominal (non-inflation-adjusted) returns than in prior periods.
Active Manager Investment Perspective
We polled a diverse set of bond portfolio managers for their perspectives on the bond market since the Federal Reserve’s communication, and while their views are subject to change, their perspectives are as follows:
• TCW MetWest’s Steve Kane, who comanages the $25 billion MetWest Total Return Fund, believes there is a 100 percent probability that the Fed will maintain its zero interest rate policy through 2013 — and a 95 percent probability through 2014.
• Jerry Lanzotti, who comanages the Lord Abbett Total Return Fund, thinks the Fed is serious about tapering its bond purchase program and that interest rate volatility will persist along with consequent volatility in other asset classes.
• Managers at Fidelity’s $13 billion Total Bond Fund are most focused on the Fed’s new data-driven approach. They believe, if the Fed tapers on the aggressive end of expectations, the worst case scenario for 10-year yields is a climb to 4 percent from their current mid-2-percent range. Given low core inflation and growth expectations, they expect a much slower climb in rates going forward.
• Lastly, PIMCO’s Bill Gross believes the Fed’s economic outlook currently driving policy is too optimistic since inflation is running close to 1 percent. Given this view, in his opinion, the recent yield increase appears overdone.
These perspectives reflect very conditional and temporal approaches and views, and investors may be left wondering what to do given the uncertain path.
Generally speaking, bond investors have several options available to help combat the impact of rising interest rates on their portfolios:
Do nothing. Either hold individual bonds to maturity and ignore price noise, mindful of credit quality, or rely on a diversified mix of bond funds with a long-term view. Remember, barring default, an unexpected early bond call, or poor trading, fixed income delivers positive absolute returns regardless of interest rate moves.
Reduce interest rate sensitivity by raising cash or seeking shorter-maturity bonds or bond funds.
Rotate away from fixed income and toward other asset classes while being mindful that other asset classes possess their own risks.
Attempt to counteract adverse bond market movements through hedging techniques involving inverse bond exchange traded funds, options, or other tools.
Adopt a combination of options two through four for a portion of the bond portfolio.
In summary, the bond market was especially volatile in the second quarter because of a significant rise in prevailing rates. While interest rates could move in any direction from here, we believe the path forward will most likely be a gradual rise over the next 18 to 24 months. In the end, bond returns will be impacted by the speed of any rate rise; the faster yields rise, the more adverse for investors. Investors can take a number of actions to reduce the potential interest-rate headwind; though, historically low interest rates have indicated that bond investors should expect total returns to be lower than recent years. We encourage you to reach out to your CAPTRUST financial advisor if you are interested in exploring concepts discussed in this article.