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Fixed income strategies for low and rising rates
In this article
- U.S. interest rates have only just begun to rise from their bottoms during the 2008-09 recession and financial crisis.
- Regardless of whether interest rates ever fully normalize, today’s low yields portend belowaverage future returns for fixed income.
- Allocating a portion of fixed-income portfolios to “plus” sectors like emerging-market, high-yield, and floating-rate debt, in addition to preferred securities, has helped investors in prior periods of rising rates.
An interest rate story
On December 30, 2008, the yield on the 10-year U.S. Treasury note fell to 2.05%, its lowest level since World War II. While rates initially rose from this point as the Great Recession wound down, they hit progressively lower bottoms in 2011, 2012 and 2016, and have yet to return to heights that, before 2008, would have been considered normal. Just over eight years into this economic expansion, U.S. stock prices have easily breached their prior highs, but interest rates, despite some upward movement of late, still dwell in the shadow of the financial crisis.
Rates remain below normal for more than one reason. With the Federal Reserve determined to keep financial conditions loose and encourage risk taking, interest rates paid on cash and other very short-term instruments hovered close to zero for many years following the Great Recession. Even though the Fed began to raise rates more than two years ago, in December 2015, the gentle pace of hikes has been slow relative to prior cycles. Longer-term U.S. Treasury yields, over which the Fed has relatively little control, have been depressed by low short-term rates, high demand from investors overseas (where rates are generally even lower), and periodic flights to quality as geopolitical jolts from China, the U.K., and the Eurozone brought flows into “safe” assets.
Bond investors now face two challenges. First, while rates remain low, those relying on bonds for their cash flow will have difficulty generating a robust income. Second, as we have witnessed recently, if rates rise only a little, the prices of existing bonds will fall. Taken together, these challenges indicate that fixed-income returns will likely be poor in the near future. So what are investors supposed to do?
While the risk of rising interest rates garners a lot of attention, we think the risk of rates remaining low for an extended period of time is more significant. Diversified investors will suffer if interest rates fail to rise further in the next several years, especially if those years include a recession. In difficult economic periods, bond prices tend to increase, providing a buffer in diversified portfolios against falling stock prices. At their current yields, though, high-quality bonds provide less protection against an equity bear market than they would if rates were higher.
And even if the next recession is still years away, an investment-grade bond portfolio will likely return, on average, only around 3% annually over the balance of this decade—before accounting for inflation. Figure 1 shows that the best predictor of 3-year returns on the Bloomberg Barclays U.S. Aggregate Bond Index (“Agg”)—a popular investment-grade or “core” benchmark—is its current yield. As interest rates have fallen since 1980, so have returns. Counterintuitively, what long-term bond investors need most right now is higher interest rates.
At their current yields, though, high-quality bonds provide less protection against an equity bear market than they would if rates were higher.
Still, history has shown that the transition from low to “normal” interest rates often involves some discomfort for bondholders. The late 1970s and early 1980s were particularly traumatic as inflation soared, wiping away the value of coupon payments and leading the Fed to hike rates drastically. It’s hard to see the dynamics preceding that crisis—an oil supply shock, wage and price controls, and a series of significant policy errors by the Fed—resurfacing in today’s environment.
The Fed hiking cycles beginning in 1994 and 2004 seem more apt for comparison, as does the market’s “taper tantrum” in reaction to the Fed choosing to end its long-standing bond purchase program in 2013. The latest stretch of rising interest rates commenced just after the June 2016 Brexit vote, when the yield on the 10-year Treasury note hit an all-time low of 1.37%. It reached a seven-year high of 3.11% in May 2018 and seems likely to climb modestly higher by year end.
While history can be a useful guide for investors, long periods of rising interest rates have been rare during the past 35 years. The shortage of historical comparisons makes quantitative solutions to the problem elusive. Nevertheless, fixed-income investors can and should prepare for the dual risks of low rates and rising rates without dramatically altering their risk tolerance or their financial goals. In the following sections, we provide some potential recommendations for doing so.
Thinking beyond the benchmark
From 1990 to 2005, a high-quality U.S. bond portfolio—using the Agg as a proxy—returned close to 7.5% per year, on average. But the Agg’s current yield of just 3.3% makes duplicating that strong performance unlikely. Consider a U.S.-based portfolio consisting of 60% equities and 40% fixed income. A five percentage point drop in fixed-income returns would cull overall performance by two percentage points per year, assuming no change in stock returns (a brave assumption and an interesting topic for another paper).
As if filling the current four percentage point return gap in the bond portfolio weren’t daunting enough, the Agg’s composition has changed meaningfully over time, making it even more sensitive to rising interest rates. To some degree, this shift has occurred because, during the global financial crisis, many bonds thought to have been of high quality turned out not to be. As a result, they are no longer included in the Agg index. At the same time, Treasury issuance has risen substantially due to greater government spending to combat the financial crisis. Consequently, the percentage of the index consisting of U.S. Treasury securities has jumped from 25% in 2005 to 38% in May 2018. (Figure 2). This has helped to raise the Agg’s average duration—a measure of interest-rate sensitivity—from 4.5 in 2005 to 6.0 today. (A 1% rise in interest rates would trigger a 6% drop in the value of the bonds in the Agg.) Overall, the Agg is positioned for weaker returns in both a low and a rising interest-rate environment than it has delivered in the past, making it a less-than-ideal index to replicate in one’s portfolio.
By looking beyond the sectors in the Agg, investors may be able to partially close the gap between historical fixed-income returns and those offered in today’s market. In our view, there are four “plus” (non-Agg) fixed-income sectors worth considering in bond portfolios. The advantages of each are described below. Figures 3 and 4 on the next page show their historical returns, volatility and correlations to one another, the Russell 3000, and the 10-year U.S. Treasury yield.
Floating-rate loans—also known as senior secured or leveraged loans—are less sensitive to rising Treasury yields because their coupons adjust to changes in prevailing rates. Thus, when rates are rising, investors in floatingrate loans generally earn higher income and experience smaller price declines. Their coupons move periodically in response to fluctuations in a reference rate, commonly the 30- or 90-day LIBOR (London Interbank Offered Rate). These regular coupon adjustments shorten the security’s duration, thereby reducing its price sensitivity to rate changes.
During periods of rising rates over the past 20 years, floating-rate loans have outperformed rate-sensitive fixed-income sectors. Issued by banks, generally to companies that are rated below investment grade, these loans have a higher risk of default and loss than investmentgrade bonds. This risk is partly offset by their senior position in the capital structure, resulting in lower default and higher recovery rates than bonds issued by the same company. In addition, floating-rate loans may improve portfolio diversification given their low correlations to most investment-grade bond categories and moderate correlation to equity prices.
High-yield bonds are typically more effective in reducing the risk of rising interest rates than many other fixed-income asset classes. Rated below investment grade, they pay a higher yield to compensate investors for greater default risk. Their higher spread over yields on Treasuries of a similar maturity serves as a cushion. These spreads can narrow when rates rise without necessarily causing high-yield bond prices to decline.
Since 1998 there have been 16 distinct occurrences of the 10-year U.S. Treasury yield increasing by 50 basis points or more.1 High-yield bonds returned, on average, 11.85% per year in those periods, compared with negative returns for investment-grade corporate debt, mortgage-backed securities, and 10-year Treasuries. Higher coupons and the positive effect of spread compression drove high-yield’s positive returns. More recently, high-yield spreads have narrowed from 487 basis points on September 30, 2016, to 362 basis points on May 31, 2018, providing less protection against market losses as rates rise. But even at these lower spreads, we think high-yield bonds’ current yields and low correlation to investment-grade bonds make them effective diversifiers.
Preferred securities—a hybrid asset class with stock and bond characteristics—may be less sensitive to the Fed’s rate hikes, particularly when it raises rates slowly. Because they are lower in the capital structure than conventional bonds and other senior debt, preferred securities have higher default risk. Therefore, they typically pay higher yields than most categories of bonds.
During the last period of gradual Fed rate increases between 2004 and 2006, they outpaced most investment-grade fixed-income asset classes—and have been doing so again during the current rate-hike cycle, which began in December 2015.2 This advantage of performing well during modest short-term rate increases, however, is partly offset by longer duration. (Many preferred securities are known as “perpetual,” meaning they don’t mature.) As a result, preferred securities are more sensitive to changes in longer-term rates, such as the 10-year Treasury, and typically perform better when rates are rising only gradually.
Two factors account for preferred securities’ potential to outperform when the Fed tightens. First, banks, which issue about 75% of all preferred securities, tend to benefit as the economy improves. Second, some preferred securities have a fixed-to-variable coupon structure, which means their dividend adjusts after a certain time period, making them less sensitive than fixed-rate securities to rising interest rates.
Emerging-market (EM) bonds
EM bonds have performed well during periods of gradually rising rates, as their relatively high credit spreads can help cushion against potential price declines. EM economies tend to benefit when rising U.S. yields reflect improving economic growth, as in the current rate-hike cycle. In this scenario, spreads tend to tighten over time, helping offset the effect of rising rates on bond prices.
EM bonds can be denominated in “hard” currencies like U.S. dollars or euros as well as in the local currencies of more than 60 countries, including Brazil, Mexico, India, and China. These bonds offer attractive spreads above U.S. Treasury yields to compensate investors for their higher risks, such as geopolitical events, a potential economic slowdown in China, and central bank missteps.
During periods of rising interest rates over the past 20 years, EM bonds returned 6.89% per year, on average, while the Agg lost an average of 3.28%. In the last two periods of Fed tightening—2004-2006 and since December 2015—EM bonds generated impressive gains of 12.12% and 9.33%, respectively.3
The 2013 taper tantrum was less friendly to EM bonds, which posted negative returns that year. Treasury rates rose rapidly amid fears that abrupt monetary tightening by the Fed could choke off EM growth. A similarly severe reaction is less likely today because EM economies are stronger fundamentally, the global economy is improving, and low inflation means central banks are likely to be gentle in applying the policy brakes.
Increase portfolio efficiency by investing outside the benchmark
In our view, investors should not decide whether or how to allocate to the sectors introduced in the previous section without considering their full effect on a portfolio. Most bondholders also have significant equity holdings, and they should be mindful that out-of-benchmark fixed-income allocations can affect their portfolios’ expected risk and return.
We address this issue in two ways. First, although it’s not possible to invest directly in an index, we consider how adding a 10% exposure to any of these four asset classes might change the characteristics of a portfolio that is allocated 60% to the Russell 3000 Index and 40% to the Agg. Second, we examine the results of combining these strategies in a “core plus” fashion to supplement traditional fixed income.
Figure 3 shows that these individual fixed-income sectors and preferred stocks all have low or negative correlations to changes in interest rates, a desirable characteristic in the current environment. Over the past 20 years, allocating a quarter of fixed-income assets—10% of the entire portfolio—to any one of them would have produced about the same risk-adjusted return as would investing in the Agg alone (Figure 5). When we include all four of the “plus” sectors together in equal measures and raise the allocation to half of the fixed-income holdings—20% of the entire portfolio—the results are similar.
These results ignore one important detail, though: we do not expect the next several years to resemble the last 20, at least with respect to the level and direction of interest rates. Indeed, we expect both the federal funds target rate and the 10-year U.S. Treasury yield to rise gradually from their current low levels in the next two to three years. We therefore consider it instructive to isolate historical periods in which interest rates were rising in order to better estimate the benefit of wider fixed-income diversification. The following summary statistics include the 16 periods since 1998 in which the 10-year U.S. Treasury yield rose by 50 basis points or more.
Two things jump out in Figure 6. First, for a 60/40 portfolio, risk-adjusted returns have been extraordinarily high during periods of rising interest rates over the past 20 years. These timeframes include the late 1990s, the mid-2000s, and much of the initial recovery from the global financial crisis—all marked by strong equity market performance—so the impressive return numbers should come as little surprise. The second point is that allocating more to “plus” sectors over interest-rate-sensitive fixed income has added to both portfolio return and portfolio efficiency during these periods.
No silver bullet, just prudent adjustments
While the future is never certain, we are confident that the long period of falling U.S. interest rates has ended. Whether we face a Japan-like era of sustained low rates or a more conventional phase of reflation and normalization, investors in traditional fixed income have a choice. They can live with the low yields offered by rate-sensitive securities, or they can alter their investment mix to include market segments with higher return potential.
We caution against removing traditional fixed income from portfolios altogether. Doing so would risk severe losses in the event of a prolonged market crisis or recession. At the same time, we believe that adding exposure to non-core fixed-income, or investing with an active fixed-income manager whose mandate is broader than the low-yielding investment-grade market, are prudent strategies for diversified investors in the current environment.
1 Nuveen, The enduring case for high-yield bonds, Spring 2018, page 4.
2 FactSet. Comparison is based on two periods of rising rates: 6/1/2004 to 6/30/2006 and 12/16/2015 to 6/30/2017. Indexes represented: BofA ML Preferred Stock Index, BBgBarc U.S. Treasury Index, BBgBarc U.S. Corporate Index, BBgBarc U.S. High Yield 2% Issuer Capped Index, BBGBarc Global Aggregate Bond Index, BBgBarc Municipal Index.
3 The two periods of rising rates were 6/1/2004 to 6/30/2006, and 12/1/2015 to 6/30/2017. Data reflect returns for JPMorgan EMBI Global Core Bond Index and fed funds rates. Sources: Bloomberg and Nuveen/TIAA Investments. It is not possible to invest in an index. Performance for indices does not reflect investment fees or transactions costs.
Risks and other important considerations
This material is presented for informational purposes only and may change in response to changing economic and market conditions. This material is not intended to be a recommendation or investment advice, does not constitute a solicitation to buy or sell securities, and is not provided in a fiduciary capacity. The information provided does not take into account the specific objectives or circumstances of any particular investor, or suggest any specific course of action. Financial professionals should independently evaluate the risks associated with products or services and exercise independent judgment with respect to their clients. Certain products and services may not be available to all entities or persons. Past performance is not indicative of future results.
Economic and market forecasts are subject to uncertainty and may change based on varying market conditions, political and economic developments.
Bonds and other fixed-income investments are subject to various risks including, but not limited to interest rate risk or the risk that interest rates will rise, causing bond prices to fall; and credit risk, which is the risk that an issuer will be unable to make interest and principal payments when due.
High-yield bonds are subject to interest rate and inflation risks, and have significantly higher credit risk than investment-grade bonds.
Investments in emerging market bonds involve higher risk. Investments in debt securities issued or guaranteed by governments or governmental entities are subject to the risk that an entity may delay or refuse to pay interest or principal on its sovereign debt because of cash flow problems, insufficient foreign reserves, or political or other considerations. In this event, there may be no legal process for collecting sovereign debts that a governmental entity has not repaid.
The investment advisory services, strategies and expertise of TIAA Investments, a division of Nuveen, are provided by Teachers Advisors, LLC and TIAA-CREF Investment Management, LLC.
©2018 Teachers Insurance and Annuity Association of America (TIAA), 730 Third Avenue, New York, NY 10017
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