Today the FOMC left its target range unchanged at 0.50%–0.75%, as expected, and reiterated that “gradual increases” in the federal funds rate are still planned. They’ve forecasted a median estimate of three 25 bps hikes in 2017, but exactly how fast and how high the U.S. Federal Reserve is actually able to raise rates this year is up for debate.
With U.S. economic data continuing to improve and the new president’s tax-cutting and infrastructure spending plans widely expected to boost inflation, interest rates have seen a slow but steady rise in recent months. With the yield on the 10-year U.S. Treasury note up more than 1.0% since mid-2016, investors are considering how a further rise in interest rates could affect the fixed income portion of their portfolios.1
Fortunately, not all fixed income securities perform the same in a rising interest rate environment. While some investments are highly sensitive to even a small rise (or fall) in interest rates, others are far less affected. This responsiveness, or duration, measures the potential impact a change in interest rates will have on its price. Generally speaking, the higher a bond’s duration, the more its price is expected to fall as interest rates go up.
Shorter maturity, higher yields
Investments that display low levels of sensitivity to changing interest rates can be a source of diversification in times of rising interest rates. One way to reduce a fixed income portfolio’s sensitivity to rising interest rates is to hold shorter-term, lower-duration investments. With rates on the rise, prices of longer-duration investments have declined, while those whose values are less affected by a change in interest rate expectations have risen.
U.S. 10-year Treasury notes, for example, are highly sensitive to even small changes in interest rate expectations. This can be a good thing when interest rates are declining, but quite the opposite when interest rates are on the rise. After returning 8.0% during the first half of 2016, 10-year U.S. Treasury notes returned -7.5% during the second half of the year as their yields rose by more than 1%.1
Because of their shorter maturities, 2-year Treasury notes have historically performed better than 10-year Treasuries during periods of rising interest rates. Likewise, senior secured loans have traditionally performed well during periods of rising interest rates.
Stronger economy, higher profits
Another way to reduce a portfolio’s sensitivity to rising rates is to focus on fixed income investments that usually perform better in a stronger economy. One such example is high yield bonds. A stronger economy typically leads to higher corporate profits, as well as declining default rates for companies at the lower end of the ratings spectrum. In fact, lower-quality credits and value-based strategies have historically outperformed the broader corporate bond benchmark during periods of rising interest rates.
The chart below shows that the total returns on high yield bonds and senior secured loans have outpaced those of their longer-duration peers, including investment grade bonds and longer-dated Treasuries.
As 10-year government bond yields rose, senior secured loans posted their 11th consecutive positive monthly return in December and their best annual return in four years. High yield bonds returned 1.6% during November and December. By comparison, investment grade corporate bonds returned -2.7%, while 10-year and 30-year U.S. government bonds returned -4.7% and -9.1%, respectively, over the same two-month period.1 This is a shift from the first half of 2016, when U.S. 10-year Treasury yields declined and high yield bonds and senior secured loans underperformed the U.S. 30-year Treasury bond.
Even with the Fed continuing to signal that interest rates will remain low by historic standards, investors searching for income need to consider the type and duration of these investments to construct portfolios with reduced sensitivity to rate hikes and ever-fluctuating market expectations.
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