Higher Rates are on the Horizon – How Bonds Keep the Faith When Prices Fall

rates

The credit crisis of 2008 is eight years in the rearview mirror, but we aren’t done dealing with the resulting low interest environment, which was brought about in an effort to stimulate the economy.

A majority of market pundits believed rates were poised to rise in 2013 based on fairly strong economic data and stabilizing financial markets, but multiple singular events drove the Federal Reserve to retain unusually low rates. In December 2015, we saw a false start after the Fed initiated its first rate hike in nearly a decade.

In 2016, an interest rate hike and the election of a strongly business-oriented presidential candidate gave rise to suspicions that higher rates were on the horizon. After years of unwinding the aftermath of 2008, advisors, investors and portfolio managers alike are concerned about where interest rates are now and the potential for additional increases in the coming months and years.

Why Isn’t My Portfolio Keeping Up?

As you can see from the chart below, U.S. 10-year Treasury yields spiked to 2.45% from 1.60% from September 30 to December 30, 2016, after the Fed pushed through a 25-basis-point rate hike and, to a greater extent, the election of a candidate whom the market believes to be more business friendly. For the first time in eight years, the market is finally seeing the potential for higher interest rates and rising inflation. Of course, when yields rise, prices fall.

rates

Clients can easily get the wrong perspective of their diversified portfolio performance in these circumstances: a relatively quick spike in interest rates, combined with record-high U.S. equity markets. We’ve had many advisors asking, on behalf of their clients, “Why didn’t my portfolio keep up with the market?” While fixed income did its job in 2016, the fourth quarter was difficult for conservative bonds, such as those issued by the government. When comparing these investments to the robust returns delivered by the stock market, bonds are shown in an unfavorable light.

Don’t Overlook the Benefits of Bonds

It is easy to overlook the benefits of bonds in the current environment. However, we have to keep a broader perspective to appreciate the power of fixed income in portfolios.

Since the unusually high interest rates of the late 1970s and early 1980s, we have witnessed only three time periods when rates significantly increased. Because bond yields and prices move in opposite directions, bond prices fell – just as we’re expecting bond prices to fall now. Even though bond prices fell during these time periods, total returns were resilient, lifted by continued coupon payments. A similar scenario now seems logical, so let’s observe what actually happened when rates rose:

rates

Bonds do have the ability to produce positive returns in a rising interest rate environment. They also play many other roles in a portfolio, including diversification, income generation and risk (volatility) reduction. That means that bonds with duration tend to do well when equities do poorly. It also means a predicable income stream in often unpredictable markets.

The table below demonstrates the negative correlations (indicating that assets tend to move in different directions) of certain components of the fixed-income market relative to equities (S&P 500 Index) over time.

rates

Better the Devil You Know: A Known Headwind Can Beat a Shock to the Portfolio

Historically, fixed income has about 6% variation from its mean, while equities have been at about 15% (Crestmont Research, “Volatility in Perspective”, January 2017). Sometimes facing a known headwind is better than facing an unknown shock to your portfolio. Given these levels of volatility, equities still possess a greater propensity to hurt your clients’ portfolios than fixed income, even in a rising interest rate environment.

Don’t outthink yourself, because even the most experienced fixed-income manager will tell you that forecasting interest rates is one of the most difficult things to do accurately and repeatedly over time. Plus, the rate component for a fixed income portfolio determines the large majority of its return over time, so a higher rate environment should translate into a higher return in the fixed income portion of the portfolio. Keep these points in mind next time a client questions the purpose of fixed income in their portfolio.

There are risks involved with investing, including loss of principal. Diversification may not protect against market risk.

Share Button
John Frownfelter

John Frownfelter

John Frownfelter is the investments contributor for Practically Speaking and the managing director of investment solutions within the SEI Advisor Network.

Learn More About John Frownfelter

Subscribe

Categories

Follow Us on Facebook

Recent Tweets