strategic research report
WHAT’S NEXT FOR THE BOND MARKET? Eric J. Freedman
a proxy for key lending rates like mortgages
CAPTRUST Chief Investment Officer
and an oft-cited gauge of bond market
Following a 30-plus-year bull market in the fixed income or bond market, the path forward is much more uncertain. While investors await the next move for fixed income, unless bond prices move higher (and, by definition, bond yields move lower), historically low interest rates indicate that bonds will offer lower total returns than most bond investors have experienced during recent periods.
movements, rose from 1.64 percent on May 1 to 2.16 percent on June 1, which in percentage terms was the largest month-overmonth increase in yield history. Through late August, the 10-year Treasury continued its rise, hovering at levels not seen since in over two years. Many yield-sensitive asset classes and sectors have had sluggish performance in sympathy with higher interest rates, including corporate bonds, municipal bonds, public real estate, and some yield-
Fears that the U.S. Federal Reserve would
producing sectors in the stock market. As
soon begin to rein in its bond-buying
investors have reached for yield across a
program have hurt fixed income in general.
variety of asset classes including those just
As a reminder, bond yields move in the
mentioned, market observers remain focused
opposite direction of prices, so when bond
on Federal Reserve guidance regarding future
yields increase, by definition their prices
accommodation, which as of press time
concurrently fall. The 10-year Treasury yield,
remained unclear. Where Will Interest Rates Go From Here?
Figure One: Yield-Oriented Assets Q2 2013 Performance
Looking at Figure Two, one can see that since the summer of 2011, 10-year Treasury
-2.3%
BarCap Aggregate Bond Index
-3.0%
BarCap Municipal Bond Index
yields have been firmly below 3 percent. This is due to global central banks’ active suppression of interest rates through buying fixed income securities in the open market
Source: Bloomberg, Zephyr
-1.4%
BarCap U.S. Corporate High Yield Index
in an attempt to encourage lending and
-7.0%
BarCap U.S. Treasury: U.S. Treasury TIPS Index
Federal Reserve has recently hinted that
-3.2%
S&P U.S. Preferred Stock Index
to slow, leaving investors to question who
spark economic activity. However, the U.S. those open market purchases could begin will replace the Fed and buy bonds. This
2.0%
Alerian MLP Index
speculation led to the second quarter’s weak bond market returns.
-3.3% -7%
-6%
-5%
-4%
-3%
-2%
-1%
Dow Jones U.S. Real Estate Index
0%
1%
2%
Per Figure Two, it appears we are approaching interest rate levels that are continued inside
"Rising yields do not always translate into bond investor losses. Two key variables will likely determine how acutely rising rates may impact bond investors: the magnitude of the rate increase and the speed at which rates increase." continued from cover
halfway between the lows seen in the
cause interest rates to hover at or near
For example, from December 2008
current levels.1
through March 2010, the 10-year Treasury
summer of 2012 and the higher levels seen
• Rates move higher: An economy
before the summer of 2011. From here,
showing resilience, the Fed backing off its
rates can do one of three things: move
recent bond purchase trend (or anticipation
lower, remain flat, or move higher.
thereof), inflationary pressures, or asset
Let’s Explore the Case for Each Scenario • Rates move lower: This scenario could happen for several reasons, most likely driven by economic weakness that causes the Fed and other central banks to continue their bond purchases. Sticky unemployment, a slowing China, continued European market malaise, and weaker equity and riskier asset classes could all cause this development. While this may seem implausible given where interest rates sit right now, we have seen them at even lower levels; the 10-year Treasury touched below 1.4 percent in July 2012, a full percentage point lower than today.
allocation movement toward riskier asset classes or foreign bonds could all drive interest rates higher. As described earlier, rising prevailing interest rates tend to hurt bondholders. Our base case scenario is for rates to rise, but to do so at a gradual pace over the next 18 to 24 months subject to numerous fits and starts depending on the economy’s health and central bank involvement. If we are wrong, we suspect it will be because a move higher happens faster than we expect, perhaps accelerated by investor overreaction to market news. The Need to Gauge Speed While higher interest rates could hurt bond investors, as Figure Three shows, rising
• Rates remain flat: A goldilocks
yields do not always translate into bond
economy, growing neither too fast nor
investor losses. Two key variables will likely
too slow, where inflation remains tame
determine how acutely rising rates may
(the Bureau of Labor Statistics notes
impact bond investors: the magnitude of the
that month-over-month change in the
rate increase and the speed at which rates
Consumer Price Index has fallen over
increase. The higher rates move and the
the past two months) and employment
shorter the time period, the more painful
and wage growth remain tepid could
the experience.
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yield rose by almost 1.5 percentage points while the BarCap Agg returned more than 8.7 percent. This was the result of a modest rate increase (as a percent of the starting yield) and a timeframe long enough for coupon payments to outweigh the price decline. Also, because the BarCap Agg is a diversified index that includes corporate and mortgage bonds, some decoupling from government bonds may have occurred. By contrast, in May, a mere 0.5 percentage-point increase in 10-year Treasury yields set the bond market back as coupons failed to offset falling bond prices over such a truncated period. In addition, since interest rates are very low, the starting yield did not provide much of a cushion against higher rates. What Can Bond Investors Expect Moving Forward? CAPTRUST research suggests that current interest rates often portend future returns. As Figure Four displays, the prevailing interest rate as measured by the 10-year Treasury provides a reasonable approximation of fiveyear forward annualized fixed income returns as measured by the BarCap Agg (note that forward returns starting in 2009 are for less than five years and are as of June 7, 2013).
So, you would interpret the chart this way:
Figure Two: U.S. 10-Year Treasury Yields (January 2010–June 2013)
in 1997, the 10-year Treasury started the year yielding 6.43 percent. During the period encompassing 1997–2002, the BarCap Agg
4.0% 3.5%
delivered a 7.42 percent annualized return. Over time, the correlation between the 10-year Treasury’s starting yield and five-year forward return has been over 0.9, a strong, positive relationship. Correlation cannot be higher than 1.0, and a correlation of 0.6 to 0.7 is considered high. Therefore, given the 10-year Treasury’s current low level, if the relationship described holds, investors should expect bond portfolios to deliver lower nominal (non-inflation-adjusted) returns than
3.0% 2.5% 2.0% 1.5% 1.0% 0.5% 0% 2010
2011
2012
in prior periods.
2013
Source: Robert Shiller, U.S. Treasury, Bloomberg
Investment Manager Perspective We polled a diverse set of bond portfolio managers for their perspectives on the
Figure Three: Periods Where 10-Year Treasury Yields Increased More Than 0.3% and Corresponding Barclays Capital Aggregate Index Returns, 1979–2013 Number of Months
Increase in the 10-year Treasury Yield
BarCap Agg Total Return
9
3.81%
-10.73%
15
5.63%
-5.81%
3.42%
-0.85%
bond market since the Federal Reserve’s
Dates
communication, and while their views are
June 1, 1979 – February 28, 1980
subject to change, their perspectives are
June 1, 1980 – August 31, 1981 May 1, 1983 – May 31, 1984
13
as follows: • TCW MetWest’s Steve Kane, who
January 1, 1987 – September 30, 1987
9
2.51%
-2.88%
October 1, 1993 – October 31, 1994
13
2.48%
-3.07%
January 1, 1996 – May 31, 1996
5
1.20%
-2.53%
Return Fund, believes there is a 100 percent
October 1, 1998 – December 31, 1999
15
1.91%
-0.40%
March 1, 2004 – April 30, 2006
26
1.22%
1.83%
probability that the Fed will maintain its zero
December 1, 2008–March 31, 2010
16
1.41%
8.76%
interest rate policy through 2013 — and a 95
May 1, 2013 – May 31, 2013
1
0.52%
comanages the $25 billion MetWest Total
-1.78% Source: Bloomberg, Zephyr
percent probability through 2014. • Jerry Lanzotti, who comanages the Lord
Figure Four: 10-Year U.S. Treasury Yield vs. Barclays U.S. Aggregate Index, 1977–2012
Abbett Total Return Fund, thinks the Fed is serious about tapering its bond purchase
20%
program and that interest rate volatility will
18%
persist along with consequent volatility in
16%
other asset classes.
14%
• Managers at Fidelity’s $13 billion Total
12%
Bond Fund are most focused on the Fed’s
10%
new data-driven approach. They believe, if the Fed tapers on the aggressive end of expectations, the worst case scenario for
6% 4%
their current mid-2-percent range. Given
2%
they expect a much slower climb in rates going forward.
Barclays Aggregate (5-year forward return)
8%
10-year yields is a climb to 4 percent from low core inflation and growth expectations,
10-year Treasury Yield (beginning of year)
1977
1982
1987
1992
1997
2002
2007
2012
Source: Federal Reserve Bank of St. Louis (http://research.stlouisfed.org/fred2), Bloomberg
continued on back 3
returns will be impacted by the speed of any rate rise; the faster yields
continued from inside
rise, the more adverse for investors. • Lastly, PIMCO’s Bill Gross believes the Fed’s economic outlook
Generally speaking, bond investors have several options available
currently driving policy is too optimistic since inflation is running
to help combat the effect of rising interest rates on their
close to 1 percent. Given this view, in his opinion, the recent yield
portfolios. Migrating to shorter-maturity bonds and less interest-
increase appears overdone.
rate-sensitive asset classes or employing a hedging strategy may
These perspectives reflect very conditional and temporal approaches
help; however, any interest rate risk strategy should be entered
and views, and investors may be left wondering what to do given the
into carefully, mindful of the costs, tax implications, and investor’s
uncertain path.
risk tolerance. Regardless, historically low interest rates indicate that bond investors should expect total returns to be lower than
Investor Choices
recent years.
The bond market has been especially volatile this year because of a significant rise in prevailing rates. While interest rates could move in
We encourage you to reach out to CAPTRUST Financial Advisors if
any direction from here, we believe the path forward will most likely
you are interested in exploring the concepts discussed in this article
be a gradual rise over the next 18 to 24 months. In the end, bond
in greater detail. Source: 1 http://www.bls.gov/cpi/cpid1304.pdf
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