The threat of rising interest rates is not good news for your fixed-income clients. With the U.S. economy transitioning from recession to recovery, it’s just a matter of time before interest rates and bond yields ratchet further upward and bond prices slide. That’s the bond market’s cyclical, predictable response to increasing issuance and inflation pressures.
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The fixed-income team at American Century Investments doesn’t foresee sudden surges in inflation or interest rates in the immediate future, but they are on the horizon. “Near-term inflation concerns remain low due to lingering weak economic fundamentals,” says David MacEwen, chief investment officer for fixed income. “However, looking long-term, the unprecedented levels of fiscal and monetary stimulus used to fight the recession will eventually result in higher inflation.”
Limiting the impact of future bond- price declines
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Core fixed-income holdings can continue to provide income and diversification benefits in wellbalanced, risk-managed investment portfolios, even in environments that are not generally favorable to many bonds. However, choosing appropriate fixed-income holdings to maintain clients’ asset allocation and diversification disciplines may become more challenging.
The key is to understand which bond sectors and maturities are most affected by expected changes in the economic and inflation picture. The instruments that performed best during recession and “flight-to-quality” periods—long-maturity traditional Treasuries—may perform worst during an economic recovery and inflation-driven bond market decline. As the recovery unfolds, short-duration fixed-income strategies with substantial non-Treasury holdings will
likely be a wiser option.
Examples of Treasury volatility
Long-maturity Treasuries typically experience the earliest, most visible and most violent price adjustments in bond market cycles. Sharp price swings in long-maturity Treasury benchmarks can create an exaggerated impression of bond volatility, even though these bonds represent a relatively small percentage of the entire bond market.For example, let’s look at two recent multi-month periods, starting with the “peak credit crisis” interval from June 16 to December 30, 2008. As investors flocked to the safest and most liquid bond instruments, the heavy demand for Treasuries drove the 10-year Treasury note yield from 4.23% to a historic low of 2.05%. This caused the note’s price to rise by nearly 20% in about seven months. Its total return, including coupon (interest), during the period was 22%.
The second interval was from January 14 to June 10, 2009, when riskier assets bounced back from the credit crisis as financial markets responded favorably to government stimulus. In this five-month period, Treasury prices declined as investors sought higher yields and higher potential returns. The 10-year Treasury yield increased from 2.20% to 3.95%, and the note’s price dropped more than 13%. Its total return was –12.33%.
A smoother ride with diversified, shorter-term bond portfolios
Clients sometimes need to be reminded that most bond sectors are not as volatile as popular long-term Treasury benchmarks. This is true, in part, because most bonds tend to yield more than Treasuries, reflecting the additional income compensation investors demand for taking on more credit risk. When rates rise, higher yields help to cushion bond-price declines.
Also, some sectors of the fixed-income market—especially corporates and municipals—can benefit from perceptions of better credit quality as economic conditions improve, which also can help to support bond prices.
Evidence of relative price stability (compared with Treasuries) in broader market bond benchmarks that include non-Treasury sectors is pervasive and compelling. Using standard deviation (the average variation from historical average returns) as a measure of volatility, broad bond market benchmarks have historically had less volatility than the Treasury sector. For example, from January 1, 1993, to December 31, 2009 (the most complete available data), the standard deviation of total returns for the Barclays Capital U.S. Aggregate Index was 3.82 from its average annual return of 6.37%, while the standard deviation of its all-Treasury component was 4.17 from its average annual return of 6.19% (source: FactSet). In other words, the diversified portfolio provided 3% more return with 8% less volatility.
Volatility was reduced even further if you shortened the portfolio’s maturity and duration, which measure the portfolio’s price sensitivity to interest rate changes. The shorter they are, the smaller the price changes to interest rate fluctuations, both up and down. Over the same recent 17-year period, the standard deviation of total returns for the short-maturity (one- to three-year) component of the Barclays Capital U.S. Aggregate Index was just 1.58 from its average annual return of 5.19%. In other words, the shorter-maturity portfolio provided 81% of the return of the longer-maturity portfolio with just 41% of its volatility.
Outperformance in rising rate environments
Of course, past performance is no guarantee of future results. But the lower volatility of short-maturity/-duration portfolios should carry considerable weight in advisors’ minds in this period of potentially higher interest rates. If you “stress test” such portfolios in scenarios where bond yields rise up to one full percentage point (100 basis points), you find that they can consistently produce small positive total returns, or small losses that are significantly lower than those suffered by longer-maturity/-duration portfolios.
This can be a valuable planning idea for clients who are facing an increasing likelihood of higher yields over the next two to three years, as inflation becomes a factor. It’s also useful for clients who want to move into short-duration/-maturity portfolios to capture more yield than is currently available in money market or cash-equivalent accounts.
American Century Investments offers a Short Duration bond fund for advisors and their clients. Its prospectus, which contains the fund’s investment objectives, risks, charges, expenses, and other information, can be obtained by calling 800-345-6488 or by visiting americancentury.com/ipro. Please read the prospectus carefully before investing.
The opinions expressed are those of the investment manager and are no guarantee of the future performance of any American Century portfolio. Statements regarding specific holdings represent personal views and compensation has not been received in connection with such views. This information is not intended to serve as investment advice.
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