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Bond Investing in a Rising Rate Environment

August 2013

BNY Mellon Wealth Management

Recent bond market volatility and worries about the end of quantitative easing have left many bond investors uneasy. The increase in rates has resulted in price declines across all fixed income sectors, as well as pronounced losses in narrowly focused strategies. This piece looks at our expectations for rates moving forward, pitfalls to avoid, and the value of active investment management in navigating any market environment.

Rates on the Rise, How Far Will They Go?

With interest rates at record lows, it was only a matter of time before rates would move higher. The degree and pace of the increase caught the market by surprise, however. As illustrated in Exhibit A, we've seen a steepening of the yield curve — a graph that plots the interest rates of like-quality bonds against their maturities.

Exhibit A // Spike in Treasury Yields

Exhibit A // Spike in Treasury Yields

As of 6/28/13. Source: Factset

Since the beginning of the year, we can see that short-term rates are anchored while intermediate- and long-term rates have been increasing rapidly over a very short time period.

While the correction in rates is somewhat overdone, it is important to note that higher rates are reflective of a strengthening economy rather than excessive inflation. This is positive news. Housing, consumer confidence and corporate balance sheets are areas of strength within the U.S. economy, providing a solid foundation for a sustainable recovery. Volatility will likely persist, however, over the next few months, as the timing and pace of the bond-purchase tapering draws near. The 10-year Treasury note rate should settle near the upper end of our revised forecast of 2.0% to 3.0% by year-end.

It's important to remember that a change in the Fed's quantitative easing program does not indicate tightening. Inflationary pressures are well within the Fed's comfort range of 2.0% to 2.5% and, as Exhibit B shows, the Fed tightening typically follows a breakout in inflation out of this range. Thus, with the Consumer Price Index registering 1.8% year-over-year, it's doubtful the Fed will tighten anytime soon. Therefore, we do not expect short-term interest rates to begin to rise until late 2014 or early 2015. Instead, we anticipate a more gradual, multi-year increase in short-term rates, averaging roughly 50 basis points per year.

Exhibit B // Core U.S. CPI vs. Overnight Fed Funds Rate

Exhibit B // Core U.S. CPI vs. Overnight Fed Funds Rate

As of 6/28/13. Source: Factset and BNY Mellon Wealth Management

Avoiding Pitfalls

Since the financial crisis, many investors have been 'playing it safe' with their portfolios — either hiding out in perceived safe-haven investments, such as U.S. Treasuries, or in some cases sacrificing diversification in the search for yield. Thus, we have been emphasizing the hidden costs associated with taking the safe route and not planning for what lies ahead. Rising rates, for example, can lead to a situation that is anything but comfortable.

As with any investment, investors can lose money in bonds. This became evident when the recent bond sell-off pushed all fixed income sector returns into negative territory for the year through June 30 (see Exhibit C). Moreover, those losses were magnified for investors who were not truly diversified. Take, for example, investors who sought higher yields through closed-end mutual funds. These funds, which employ leverage to boost returns, suffered outsized losses in June, bringing year-to-date returns to roughly -11% versus the Barclays Aggregate Index's return of -2.4%.

Treasury Inflation Protected Securities (TIPS) provide another example of the pitfalls of solely focusing on safety and not fully understanding one's investments. TIPS returns were previously bolstered by growing concern about accelerating inflation. However, with inflation expectations falling and the price of TIPS correcting as interest rates were poised to start rising, the TIPS sector has seen outsized negative returns.

For those investors lured by the attractive yields of emerging markets debt, softer growth outlooks led to a drastic sell-off in this sector, which was exacerbated by an investor exodus to less risky fixed income alternatives.

Exhibit C // Selected Sector Returns

Exhibit C //Selected Sector Returns

As of 6/30/13. Source: Barclays Capital

As these examples illustrate, diversification within fixed income, to include sectors that may respond differently to changes in interest rates, is extremely important in this environment of increased volatility and rising rates. We have advocated a broadly diversified fixed income portfolio consisting of core, high quality bonds as well as higher yielding sectors. Diversification alone is not enough, however. Active management and a disciplined approach to investing will help mitigate risks and uncover opportunities in any type of market environment.

Positioning Portfolios for What Lies Ahead

At BNY Mellon Wealth Management we have positioned portfolios for an environment of modest economic growth, muted inflation, lower expected total returns and gradually rising long-term rates. Although the Fed has announced that it will slow its massive bond-buying program later this year, the pace and timing will ultimately depend on the strength of the economy. Because of the constantly changing economic landscape and resulting overreactions, we believe it is best not to try and time the market. Instead, we have advocated adherence to a disciplined approach, adding portfolio value by making active, nimble adjustments that help protect portfolios while capitalizing on market opportunities.

There are several strategies we utilize to position portfolios: duration and coupon management, yield curve positioning and an emphasis on higher yielding sectors which are typically less sensitive to rising rates.

Shortening duration can make a portfolio less sensitive to rising interest rates. However, a better approach is to allow a portfolio to shift to a shorter duration over the next year and a half, when we expect short and intermediate rates to actually rise. Going short too soon can be anything but comfortable. If rates stay at current levels or move lower, a shorter-duration portfolio that sacrifices yield for safety will generate less income and become more costly over time.

Adjusting the portfolio's position along the yield curve is another technique used to manage interest rate risk. Currently, the yield curve is very steep. When this occurs it is beneficial to emphasize short- to intermediate-term maturity bonds rather than the long end of the curve. The combination of bonds along the curve depends on where we see rates increasing the most, as well as the level and shape of the curve. Historically, when the Fed begins to increase short-term rates, the yield curve tends to flatten. Thus, a different combination of maturities, based on where we see value, may be appropriate.

Incorporating higher yielding sectors can help manage portfolio sensitivity to changing interest rates while providing additional income. These sectors include investment-grade corporate bonds, municipals, high yield and emerging markets debt. Despite the greater credit risk and volatility of higher yielding sectors, the additional yield can help cushion a rise in interest rates.

A higher rate environment also means higher coupon yields on newer bond issuance. Thus, for those investors who have made a decision to invest their portfolios in cash, it may be appropriate to develop a plan to deploy those assets incrementally in newly issued bonds to take advantage of these higher rates.

We see a breadth of opportunities in today's market and look to take advantage of dislocations in many segments. In addition, more flexible strategies, such as floating rate loans, can add value in a rising rate environment. This type of strategy should perform well as short-term rates begin to rise, since the additional coupon income from the higher adjusted rates can potentially add to total return.

Lastly, in a rising interest rate environment, tax-loss harvesting opportunities are likely to emerge, making the benefits of year-round tax management of fixed income portfolios very compelling. Active fixed income managers have a tremendous advantage in these situations, due to their ability to properly execute tax-loss harvesting.

New Environment, Disciplined Approach

The fixed income landscape has changed. Lower expected total returns, a normalization of rates from unprecedented low levels and increased volatility have become the new normal. Given the environment, investors should take the time to ensure that their portfolios are aligned with what they want to accomplish with their wealth. This typically entails some exposure to fixed income, for preservation of capital or income. Based on our expectations for inflation, interest rates and future economic conditions, a portfolio construction of core, high quality bonds as well as higher yielding strategies should provide diversification benefits as well as add yield to portfolios over the longer term.

In any environment, BNY Mellon Wealth Management believes that a disciplined, active management approach, which combines a top-down view of the markets with a bottom-up, research-driven focus, will continue to most effectively uncover value and manage risk for investors.

 

The information provided is for illustrative/educational purposes only. All investment strategies referenced in this material come with investment risks, including loss of value and/or loss of anticipated income. Past performance does not guarantee future results. This material is not intended to constitute legal, tax, investment or financial advice. Effort has been made to ensure that the material presented herein is accurate at the time of publication. However, this material is not intended to be a full and exhaustive explanation of the law in any area or of all of the tax, investment or financial options available. The information discussed herein may not be applicable to or appropriate for every investor and should be used only after consultation with professionals who have reviewed your specific situation.

Pursuant to IRS Circular 230, we inform you that any tax information contained in this communication is not intended as tax advice and is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.

BNY Mellon Wealth Management conducts business through various operating subsidiaries of The Bank of New York Mellon Corporation.

© 2013 The Bank of New York Mellon Corporation. All rights reserved.

08/2013