Rising Interest Rates: The Importance of Fixed Income Investments

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June 27, 2014


Since Janet Yellen assumed the reins of the Federal Reserve in February 2014, investors have tried to anticipate the new Chair’s action with regard to quantitative easing (QE). Because the new members of the 2014 Federal Open Market Committee generally have favored less easing, the timing of the first policy rate increase is expected to accelerate to the first half of 2015, albeit at a slower pace than in past tightening cycles.

 

What might that mean for Treasury yields? “As QE is reduced, the range of possible yield becomes larger, which may lead to increased interest rate volatility,” says Jennifer Vail, Head of Fixed Income Research for U.S. Bank Wealth Management.

 

For example, potential yield outcomes for the 10-year Treasury with QE might range from 1.5percent to 3.5 percent, according to 2014 datafrom financial research company FactSet; without QE, yields might range from 0 percent to 7 percent.

A Gradual Rise in Interest Rates

Over the next few months, Vail believes the yield curve will remain steep and interest rates will continue to rise gradually — although the scope for interest rates to rise significantly appears limited.

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June 27, 2014


That’s not to say investors should eliminate exposure to this asset class. “The typical role of fixed income in a diversified portfolio is to not only potentially generate income but also narrow the dispersion of return outcomes and potentially reduce the risk profile,” Vail says. “Even in a rising interest rate environment in which bonds can lose value, the losses bond investors experience are historically small compared to equity losses.”

 

Click graph to enlarge

Comparing performance of bonds versus stocks before and after the recent global financial crisis; Source: Vanguard, data compiled 12/31/13

Still, investing in fixed income securities is subject to risks including changes in interest rates, credit quality, market valuations, default, liquidity, prepayments, early redemption, corporate events and tax ramifications. Investments in debt securities typically decrease in value when interest rates rise; this risk is usually greater for longer- duration debt securities. Investments in lower-rated and non-rated securities present a greater risk of loss to principal and interest than higher-rated ones.

 

Fixed Income Investments in a Rising Interest Rate Environment

Here’s what bond investors might consider about the various fixed income sectors:

 

High yield: High yield historically has been the least sensitive sector to interest rate rises. Plus the higher coupons often offered by high yield may offset capital losses sustained when interest rates increase.

 

However, high-yield bonds involve risks such as changes in economic conditions or other circumstances that may adversely affect a bond issuer’s ability to make principal and interest payments.

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June 27, 2014


Municipal bonds: “We believe municipal bonds are modestly more attractive in 2014 than in 2013. We don’t expect a major tax code overhaul in 2014, so legislation modifying the tax-exempt status of municipal bonds is unlikely in our opinion,” Vail says. “Additionally, as municipalities deleverage, they reduce their amount of outstanding debt; more investors may seek a smaller number of issues, possibly creating upward price pressure on municipal debt.

 

Investment-grade Fixed Income: During the next few months as longer-dated Treasury yields may move higher, the typically lower-durationcorporate bonds of the financial sector may outperform the corporate bonds of the industrial and utilities sectors. Banks also can benefit from a steep yield curve, where they can pay low interest rates on deposits and collect higher interest rates on loans.

 As we get closer to the Fed’s first interest rate hike, utilities corporate bonds may begin to outperform financial and industrial corporate bonds.

 

Emerging markets: Emerging debt remains an attractive sector to us, and we believe emerging economies are more resilient to market stress than they were 10 years ago. However, the U.S. dollar likely will continue to appreciate as the Fed removes stimulus and the domestic economy strengthens, which may create a headwind to non-dollar denominated debt. “In emerging markets, we encourage investors to focus on the U.S. dollar or hard currency options in lieu of local currency choices,” Vail says.

 

Of course, investing in emerging markets may involve greater risk, and a concentration of investments in a single region may result in greater volatility.

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June 27, 2014


Developed markets: “We remain wary of developed market international bonds,” Vail says. “Yield levels are at very low levels in most advanced economies, so valuations aren’t overly compelling.”

 

Keep in mind that international investing involves special risks, including foreign taxation, currency risks, risks associated with possible differences in financial standards, and risks associated with future political and economic developments.

 

Treasuries: We encourage clients to avoid adding positions in interest rate-sensitive sectors like Treasuries.

 

Mortgage-backed Securities (MBS): Higher long-term rates may dampen refinancing, which extends the duration and accelerates the price declines of MBS. And as the Fed concludes its purchase program, a large buyer of MBS will leave the market and may put upward pressure on spreads.

Remember, too, that MBS include credit risk, prepayment risk, possible illiquidity and default, as well as increased susceptibility to adverse economic developments.

 

Intermediate Treasury Inflation-protected Notes (TIPS): TIPS are likely to be vulnerable to a reduction in accommodation. As stimulus is lessened, the downward pressure on real interest rates will likely be alleviated, leaving TIPS exposed to price declines.

 

Additionally, TIPS offer a lower coupon compared to other similar investments. The principal value and the income paid out may increase or decrease with the rate of inflation. Gains in principal are taxable in that year, even though not paid out until maturity. In the event of sustained deflation, the amount of the semiannual interest payments and the inflation-adjusted principal amount of the security will decrease. However, all TIPS are paid out at the original issue face amount at maturity.

 

The guarantee provided by the U.S. government to TIPS relates only to the prompt payment of principal and interest, and does not remove the market risks of investing in these types of securities.

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June 27, 2014


Rising Interest Rates: The Bottom Line

Because all rising interest rate environments are not created equal, investments may need to shift to different parts of the curve:

 

  • In the steeper portions of the yield curve, investors who favor moderate maturities could potentially be compensated for interest rate risk.
  • In advance of a rise in interest rates, a focus on higher coupons within all sectors and all credit qualities of the fixed income market may provide a more defensive tilt.
  • As an actual increase in the Fed funds rate approaches, a barbell strategy — purchasing long and short securities while reducing exposure to immediate securities — may be beneficial as we move toward a flattening yield curve environment.
  • Once the Fed begins to raise rates, investors might shift to an intermediate to long portfolio.

“Even amidst tapering of QE, increased volatility and rising interest rates, most investors should consider including fixed income investments as part of a broadly diversified portfolio mix,” Vail says. “These long-term allocations should remain intact even with concerns about today’s interest rate environment.”


This article was adapted from The Private Client Reserve’s situation analysis paper, “Investing in a Rising Interest Rate Environment.”

 

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