Laddered Bond Portfolios: Built to Perform in Rising Rate Environments Josh Yafa | Client Portfolio Manager
As the Federal Reserve prepares to embark on a path of interest rate policy normalization, fixed income investors are finally facing the beginning of a cycle they have feared for the better part of a decade. Yet with answers come more questions, and while investors can reasonably expect a series of Federal Funds rate increases (hereafter, “Fed Funds”), the pace, magnitude and ripple effects on various segments of the broader fixed income market are open to interpretation. Periods of increasing interest rates, long anathema to fixed income investors, seem to be frequently misunderstood and can lead to binary and often counterproductive decision-making behavior. Here we examine the impact of rising rate environments on various fixed income investment strategies as measured by periods in which both of the following occurred: the Fed was in a tightening cycle, i.e., hiking Fed Funds, and the bond market reacted strongly, which we define as an increase in 10-year U.S. Treasury yields of greater than 100 bps (1%) over the course of 12 months.
Fundamentally, predicting the forward path of the Fed Funds rate is a difficult exercise driven by an unwieldy combination of dependent and independent variables. After each meeting, the Federal Open Market Committee’s Board of Governors (hereafter, “the Fed”) publish their so-called “Dot Plot,” a forward-looking projection of policy rates assuming normal economic conditions. Time and history allow us the luxury of tracking the accuracy of the Fed’s interest rate predictions versus the future that actually unfolded; an unfair measuring stick, perhaps, but such is the life they’ve chosen. In Chart 1 we can see a series of end-of-year Fed Funds projections as predicted by the individual governors during their first annual meeting of each calendar year. The titles on top indicate the meeting year, while the labels on bottom show the specific end-of-year (EOY) interest-rate predictions for the current or subsequent years (so, it is the case that end-of-year 2013 predictions were made at both the 2012 and 2013 meetings, and so forth and so on).
Source: Federal Reserve.
Each colored circle indicates the value (rounded to the nearest 1/8 percentage point for the 2015 meeting and to the nearest 1/4 for prior years) of an individual FOMC participant’s judgment of the appropriate level of the federal funds rate at the end of the specified calendar year.
As the data shows, even the Fed, arguably in possession of the best real-time macroeconomic data available, is frequently incorrect with its estimation of the future. Keep in mind that these are the very people who set the Fed Funds rate.
Well, if not the Fed, perhaps “the market” usually gets it right? One could likely find value in this logic, given the intense investor scrutiny and sheer amount of global capital riding on the back of policy rates. In Chart 2 the market’s historical expectations for interest rate increases are visible via snapshots of the Fed Funds futures market. Much like the “Dot Plot,” Fed Funds futures also missed the mark as shown by historical expectations for more rapid rate hikes than those that actually occurred. It seems that to trust in specific interest rate timing predictions could be folly — at least according to the recent data. More often than not, the market has likely been on the wrong side of the rates trade post-financial crisis. Needless to say, over the past several years investors positioned to avoid interest-rate risk due to a prediction of a specific Fed Funds lift-off date could have suffered significant opportunity costs if Charts 1 and 2 are to be believed.
Source: Bloomberg as of 3/31/15.
If a quick look back at the Fed and the market shows us anything, it is hopefully a restatement of the obvious: attempting to predict the future is challenging. With that as a backdrop, investors must choose whether they trust in manager skill to overcome the problem of increasing interest rates by outsmarting the complicated puzzle laid out above. Some managers, mind you, have been quite successful at navigating this labyrinth in periods past. But, perhaps an alternative solution to the problem of rising rates could come from a directional investment view rather than period-specific view, and one that balances the synchronized and ever-present risks of duration, reinvestment and liquidity.
Laddered Bond Portfolios – Benefits of laddering
Though laddered bond portfolios can be beneficial in many interest rate environments, we will specifically focus on rising rate scenarios. Generally speaking, over long time periods laddered strategies tend to perform well against barbell or bullet bond strategies. This is principally due to the following concepts; one, laddered portfolios capture price appreciation as bonds roll down the curve and their remaining life shortens; two, in a normal (upward sloping) yield curve environment laddered portfolios benefit from constantly reinvesting principal from maturing bonds into new higher-yielding bonds.
For illustration purposes only. Not representative of an actual investment.
Conceptually, in a rising rate environment a laddered bond portfolio balances the specter of price volatility vis-à-vis duration with the benefit of increasing income. While one side of the see-saw is initially weighed down by price declines, the income side eventually gains enough mass through reinvestment into higher-yielding bonds to reverse the imbalance. Furthermore, as bonds near maturity their prices accrete towards par and initial price declines dissolve.
A key element, of course, is a reasonable investment period. After all, an itchy trigger finger on the “sell” button could realize losses if liquidity is demanded at a time when bonds are trading at a loss due to increasing interest rates. It is necessary to allow enough time for bonds to do what they do — that is, pay a reliable income stream from which a predictable total return can be captured. For this reason, we examined three-year annualized returns during past periods of increasing Fed Funds target rates in Chart 4.
Since 1990, there have been four discrete periods during which the Fed raised the federal funds rate and the bond market reacted strongly, again which we define as a back-up in 10-year U.S. Treasury yields of greater than 100 bps over the course of 12 months. The combination of these events occurred during the following time periods: