Bond Strategies for a Period of Rising Rates
May 7, 2018
Not all bonds have reacted the same during previous periods of rising rates.
- The 25-year “bull market for bonds” generally has been a period of declining rates, but there have been eight periods when rates rose sharply.
- The performance of long-duration government-related securities suffered the most during those eight periods, while lower-duration and more credit-sensitive bonds historically performed well.
- If we continue to see a move to higher U.S. Treasury yields, we expect that short-duration bonds, floating-rate notes, high-yield bonds, and bank loans will have the potential to outperform core bonds.
Media attention recently focused on the yield on the 10-year Treasury bond as it approached the 3.0% level in April. It briefly surpassed that level late in the month, before falling back to 2.95%, as of the week ended May 4. While breaching the 3% level attracted many headlines, this recent move in rates started last fall, when the yield on the 10-year bottomed out, at 2.04%. With that in mind, this week we review the performance of various fixed-income asset classes during previous periods of rising interest rates.
Chart 1 tracks the yield on the 10-year Treasury bond over the past 25 years. This long-term “bull market for bonds” generally has been a period of declining interest rates. However, this bull market has not moved in a straight line. Here, we identify eight separate periods when the 10-year Treasury yield jumped by more than 100 basis points (bps) over a short period of time. 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.
Chart 1. The 25-Year “Bull Market in Bonds” Has Included Several Periods of Rising Rates
Eight periods of greater than 100 bps rise in 10-year U.S. Treasury yield,* April 30, 1993–April 30, 2018.
Source: Bloomberg, Morningstar. Ten-year Treasury yield as represented by the Bloomberg Barclays Generic 10-Year U.S. Government Note Index. Ten-year Treasury performance as represented by the Citigroup 10-Year Treasury Bond Index. *Rise of 100 bps must have occurred within a 16-month time period. Past performance is not a reliable indicator or guarantee of future results. Performance during other periods may have been different. Other indexes may not have performed in the same manner under similar conditions. For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment.
How did other asset classes fare? Table 1 indicates that longer-duration government-related securities suffered the most, while lower-duration and more credit-sensitive bonds historically performed well. The representative benchmark, the Bloomberg Barclays U.S. Aggregate Bond Index, which now has an effective duration of 6.1 years and is largely comprised of U.S. Treasuries and government-related securities, generated losses in seven of these eight periods.
Table 1. Historically, Lower-Duration and Credit-Sensitive Bonds Have Performed Well in Periods of Rising Long-Term Yields
Index returns during the eight periods of greater than 100 basis point rise in the 10-year U.S. Treasury yield. month-end annualized returns
Source: Morningstar. Citigroup 10-Year Treasury Bond Index. Bloomberg Barclays U.S. Aggregate Bond Indexv Bloomberg Barclays U.S. Floating Rate Note Index. ICE BofA Merrill Lynch U.S. Corporate BBB-Rated 1-3 Year Index. Credit Suisse Leveraged Loan Index. ICE BofA Merrill Lynch U.S. High Yield Constrained Index. ICE BofA Merrill Lynch Global High Yield Index. ICE BofA Merrill Lynch All Convertibles All Qualities Index. S&P 500 Index. Past performance is not a reliable indicator or guarantee of future results. Performance during other periods may have been different. Other indexes may not have performed in the same manner under similar conditions. For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment.
Moving down to lower-duration and lower-rated credit, one can see positive returns, for all eight periods, in short-term corporate bonds, high-yield corporate bonds, and floating-rate bank loans. Looking at equity-related securities, one can see 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. 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 securities—Securities with floating-rate coupons do not have the duration exposure of typical fixed-rate bonds, so prices are not affected by moves in long-term rates. With coupons that adjust with short-term rates, typically every 90 days, they can benefit from a rise in short-term rates such as Libor (the London interbank offered rate, which typically moves in line with the fed funds rate). Bank loans generally are issued by below investment-grade companies, and so the loans also can benefit from an improving credit environment typically associated with rising rates. Investment-grade floating-rate notes (FRNs) can provide the benefits that come with adjustable-rate coupons, albeit at a lower yield, within an investment-grade asset class.
The recent move in the 10-year bond yield has not quite reached the 100 basis-point level referenced in Table 1, but we have included the performance of those same indexes below for the period since the recent low in yields. While the numbers are different, the relative performance is the same: rising Treasury yields have led to negative returns for longer-duration, government-related indexes, while shorter duration and more credit-sensitive sectors have outperformed. Convertible bonds have rallied along with the strong performance of the equity market.
Table 2. Recent Experience Has Demonstrated the Same Relative Performance
Source: Morningstar. Citigroup 10-Year Treasury Bond Index. Bloomberg Barclays U.S. Aggregate Bond Index. Bloomberg Barclays U.S. Floating Rate Note Index. ICE BofA Merrill Lynch U.S. Corporate BBB-Rated 1-3 Year Index. Credit Suisse Leveraged Loan Index. ICE BofA Merrill Lynch U.S. High Yield Constrained Index. ICE BofA Merrill Lynch Global High Yield Index. ICE BofA Merrill Lynch All Convertibles All Qualities Index. S&P 500 Index. Past performance is not a reliable indicator or guarantee of future results. Performance during other periods may have been different. Other indexes may not have performed in the same manner under similar conditions. For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment.
As we have highlighted in previous articles, not only have investment-grade FRNs and bank loans been able to generate positive returns in the face of rising rates but they also have benefited from a rapid rise in short-term rates, as their coupons have been adjusting higher over the past few months.
Short-term corporate bonds basically have been flat, with a return of -0.16% over this eight-month period, outperforming the Bloomberg Barclays Aggregate Index by more than 200 bps. Short-term corporates were able to maintain their ground compared to the negative returns in many other segments of investment-grade fixed income.
But during this period, there was also a large move in short-term rates, putting short-term corporate bonds in a much better position to generate returns going forward. For example, as illustrated in Chart 2, the average yield on the ICE BofA Merrill Lynch 1- to 3-Year Corporate Bond Index has increased by more than 100 bps since September 2017, and by more than 200 bps since early 2014. With an average yield on the index of 3.1%, short-term corporate bonds may provide a source of attractive income, with limited duration and volatility compared to longer-duration options.
Chart 2. Short-Term Corporate Yields Have Increased Substantially
Average yield to worst, ICE BofA Merrill Lynch 1-3 Year Corporate Bond Index, May 2013–May 2018
Source: Bloomberg. For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment.
With history as our guide, if we continue to see a move to higher U.S. Treasury yields, we would expect that short-duration bonds, high-yield bonds, and floating-rate loans would have the potential to outperform core bonds. Of course, we cannot rule out a flight to quality should a risk-off market event occur, and some investors may want to be prepared for such an event.
A prudent approach to the current environment may be maintaining a diversified portfolio (e.g., one that includes allocations to high-quality core bonds, short-duration bonds, high-yield bonds, and bank loans) or alternatively a multi-sector strategy that gives the manager the flexibility to invest across investment-grade, high-yield, and equity-related securities in order to position the portfolio most appropriately for the given economic environment.
This Market View may contain assumptions that are “forward-looking statements,” which are based on certain assumptions of future events. Actual events are difficult to predict and may differ from those assumed. There can be no assurance that forward-looking statements will materialize or that actual returns or results will not be materially different from those described here.
A Note about Risk: The value of investments in fixed-income securities will change as interest rates fluctuate and in response to market movements. Generally, when interest rates rise, the prices of debt securities fall, and when interest rates fall, prices generally rise. Bonds may also be subject to other types of risk, such as call, credit, liquidity, interest-rate, and general market risks. High-yield securities, sometimes called junk bonds, carry increased risks of price volatility, illiquidity, and the possibility of default in the timely payment of interest and principal. Moreover, the specific collateral used to secure a loan may decline in value or become illiquid, which would adversely affect the loan’s value. Longer-term debt securities are usually more sensitive to interest-rate changes; the longer the maturity of a security, the greater the effect a change in interest rates is likely to have on its price. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise. Lower-rated bonds may be subject to greater risk than higher-rated bonds. No investing strategy can overcome all market volatility or guarantee future results. Statements concerning financial market trends are based on current market conditions, which will fluctuate.
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.
A basis point is one one-hundredth of a percentage point.
Duration is the change in the value of a fixed-income security that will result from a 1% change in market interest rates. Generally, the larger a portfolio’s duration, the greater the interest-rate risk or reward for underlying bond prices.
A bond yield is the amount of return an investor will realize on a bond.
In the United States, federal funds (often referred to as fed funds) are overnight borrowings between banks and other entities to maintain their bank reserves at the U.S. Federal Reserve. Banks keep reserves at Federal Reserve Banks to meet their reserve requirements and to clear financial transactions.
The London interbank offered rate (Libor) is an interest rate at which banks can borrow funds, in marketable size, from other banks in the London interbank market.
The Bloomberg Barclays Generic 10-Year U.S. Government Note Index is comprised of generic U.S. on-the-run note indexes. Yields are based on the ask side of the market are and updated intraday. (An on-the-run security is the most recently issued, and hence potentially the most liquid, of a periodically issued security.)
The Bloomberg Barclays U.S. Aggregate Bond Index represents securities that are SEC-registered, taxable, and dollar denominated. The Index covers the U.S. investment-grade fixed-rate bond market, with index components for government and corporate securities, mortgage pass-through securities, and asset-backed securities. Total return comprises price appreciation/depreciation and income as a percentage of the original investment.
The Bloomberg Barclays U.S. Floating Rate Note Index is designed to measure the performance of U.S. dollar-denominated, investment grade floating rate notes.
The ICE BofAML Global High Yield Index tracks the performance of USD, CAD, GBP and EUR denominated below investment grade corporate debt publicly issued in the major domestic or Eurobond markets.
The ICE BofAML U.S. High Yield Master II Constrained Index tracks the performance of US dollar denominated below investment grade corporate debt publicly issued in the US domestic market. Qualifying securities must have a below investment grade rating (based on an average of Moody’s, S&P and Fitch), at least 18 months to final maturity at the time of issuance, at least one year remaining term to final maturity as of the rebalancing date, a fixed coupon schedule and a minimum amount outstanding of $100 million.
The ICE BofAML U.S. Corporate BBB-Rated 1-3 Year Index is an unmanaged index comprised of U.S. dollar denominated investment grade corporate debt securities publicly issued in the U.S. domestic market with between one and three year remaining to final maturity.
The ICE BofAML U.S. Convertible All Qualities Index tracks the performance of publicly issued U.S. dollar-denominated convertible securities of U.S. companies. Qualifying securities must have at least $50 million face amount outstanding and at least one month remaining to the final conversion date.
Source ICE Data Indices, LLC (“ICE”), used with permission. ICE PERMITS USE OF THE ICE BofAML INDICES AND RELATED DATA ON AN “AS IS” BASIS, MAKES NO WARRANTIES REGARDING SAME, DOES NOT GUARANTEE THE SUITABILITY, QUALITY, ACCURACY, TIMELINESS, AND/OR COMPLETENESS OF THE ICE BofAML INDICES OR ANY DATA INCLUDED IN, RELATED TO, OR DERIVED THEREFROM, ASSUMES NO LIABILITY IN CONNECTION WITH THE USE OF THE FOREGOING, AND DOES NOT SPONSOR, ENDORSE, OR RECOMMEND LORD ABBETT, OR ANY OF ITS PRODUCTS OR SERVICES.
The Citigroup 10 Year Treasury Bond Index is a broad measure of the performance of medium-term U.S. Treasury securities.
The Credit Suisse Leveraged Loan Index is designed to mirror the investable universe of the U.S. dollar-denominated leveraged loan market.
The S&P 500® Index is widely regarded as the standard for measuring large cap U.S. stock market performance and includes a representative sample of leading companies in leading industries.
A Note about Indexes: Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment. Indexes depicted herein are for illustrative purposes only and do not represent any specific portfolios managed by Lord Abbett or any particular investments. Other indexes may not have performed in the same manner under similar conditions.
The credit quality of the securities in a portfolio is assigned by a nationally recognized statistical rating organization (NRSRO), such as Standard & Poor’s, Moody’s, or Fitch, as an indication of an issuer’s creditworthiness. Ratings range from ‘AAA’ (highest) to ‘D’ (lowest). Bonds rated ‘BBB’ or above are considered investment grade. Credit ratings ‘BB’ and below are lower-rated securities (junk bonds). High-yielding, non-investment-grade bonds (junk bonds) involve higher risks than investment grade bonds. Adverse conditions may affect the issuer’s ability to pay interest and principal on these securities.
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