Since the early 1980s, bond investors have benefitted from declining interest rates. But we may be turning to a future of rising rates and clients suffering bond losses. Advisors need to be prepared both in terms of investment strategy recommendations and communication with clients.

The presidential election may have provided a preview of things to come. On Election Day the 10-year Treasury bonds were yielding 1.88%, but by mid-December yields had increased 72 basis points to 2.60%. Inflation-protected securities (TIPS) saw an increase of 55 basis points over the same period. For the 4th quarter of 2016 bond funds posted losses. The Vanguard Intermediate-Term Treasury fund (VFITX) lost 3.42% and their intermediate-term corporate bond fund (VICSX) lost 3.39%. There was less impact on Vanguard Inflation-Protected Securities, down 2.69%.

Yields have leveled off since year-end. Should we expect yields to remain at current levels, which are well below historical averages, or should we expect further increases? The general consensus among investment managers and economists is that we are on an upward trend. Jeffrey Gundlach, in this post-election Barron’s article, predicted that the 10-year Treasury will hit 6% in the next four to five years. Bill Gross predicted increases, but not as steep. He expects continued rate repression from international central banks to dampen increases. The latest Wall Street Journal monthly survey of more than 60 economists predicted the 10-year Treasury at year-end yielding 2.86% and a further increase to 3.10% by the end of 2018.

If we are indeed on an upward trend, clients will be seeing more bond losses.

Misconceptions

It’s only natural for clients to view that:

  • The Fed controls interest rates, both short-term and long-term;
  • Market-value losses on bond portfolios are bad; and
  • Advisors should be able to avoid such losses.

Given the complex nature of fixed income markets, it’s certainly understandable why many would hold such beliefs. Unfortunately, these beliefs are not easy to counter. Building better client understanding requires explaining the subtleties of the bond market.

Regarding the Fed, my own clients have at times asked this question: “I’ve heard the Fed will be raising rates – shouldn’t we do something?” To address this concern it is useful to look at the relationship between Fed actions and longer-term interest rates. Unfortunately, we have only limited experience of Federal Funds rate increases while Janet Yellen has been chair, although we certainly expect more this year. That limited experience has demonstrated a disconnect between moves in the Funds rate and rates for longer maturities. On December 16, 2015 the Fed raised the Funds rate from the 0% – 0.25% range to 0.25% – 0.50%. The day before the rate increase the 10-year Treasury yield was 2.28% and the day after at 2.24%. The yield dipped as low as 1.37% in mid-2016 before the increasing later in the year.

On December 14, 2016 the Fed did another Funds rate increase to the 0.50% – 0.75% range. There may have been a slight impact on longer maturities with the 10-year Treasury rising from 2.48% the day before to 2.60% the day after, but rates then dipped slightly for a few months. The most recent increase was on March 15, 2017 and the yield dropped from 2.60% to 2.52% when the Fed made the announcement.

The Fed does indeed control the Federal Funds rate and this rate influences other short-term yields. However, any influence of the Fed on longer maturities is much more tenuous.

But even without a direct Fed connection, we do have forecasts of longer-term rates increasing. Bond mathematics dictate that when rates go up, bond portfolios show losses, as with the 4th quarter Vanguard results mentioned above. When clients see losses on their investment statements they may naturally ask, “Why do you have me in investments that lose money?” This is more of a challenge to address than the Fed connection, and requires taking a closer look at the information investment statements provide.

Rising Rates

Rising Rates

By Joe Tomlinson, read the full article here.