Key Takeaways

  • High-quality bonds have cheapened from their low yields in July 2016, offering higher yields in most sectors.
  • With interest rates on the rise, short-term bonds may represent a better risk/reward relationship for defensive portfolio positioning.
  • Scenario analysis shows that if rates rise, short-term bonds may outperform intermediate maturities.

With shorter-maturity yields increasing as of late, the front end of the yield curve (shorter-maturity fixed income) may be offering an enticing relationship between risk and reward, and a potential place for investors to play defense. We’ve heard the adage before that the best defense is a good offense. But with interest rates on the rise, perhaps a good defense would trump a good offense. For the second time in three months, the Federal Reserve (Fed) is poised to raise interest rates (see our recent Weekly Economic Commentary). This has set a negative tone in fixed income markets and left investors wondering if bond prices have bottomed, or if more losses are still to come. Sector selection and yield curve allocation decisions are difficult decisions in rising rate environments, but with scenario analysis, we can begin to determine how portfolios may perform in this challenging market.

The Bloomberg Barclays Aggregate Bond Index, the most widely used high-quality bond benchmark, serves as a good example of the price weakness that has surfaced in fixed income. The index, which is mostly comprised of Treasury bonds, securitized mortgage-backed securities, and investment-grade corporates, saw yields rise from a low of 1.82% in July 2016, to a high of 2.78% recently [Figure 1]. Cheaper prices, coupled with shorter-maturity yields adjusting more dramatically to the Fed rate hikes, present investors with an opportunity to reduce interest rate sensitivity, while not sacrificing a lot of yield, thus playing defense in this volatile market.

Higher Yields Maturities

Maturities

With the focus on Fed rate hikes, and inflation gradually moving higher, conditions have favored risk assets (such as stocks) and been a headwind for fixed income assets since early November, because there is an inverse relationship between bond prices and interest rates. As a result, bonds have been getting cheaper relative to stocks, increasing their attractiveness. For example, the U.S. Treasury 10-year bond yield is now at 2.58%, more than 1.2% higher than its 1.36% low yield last July. This is 65 basis points (0.65%) higher than the estimated S&P 500 dividend yield (2.58% vs. 1.93%), making the 10-year Treasury cheaper than stocks using this metric. The last time this occurred was September 2014 and bond investors who took advantage of the cheaper prices were rewarded as the 10-year Treasury note rallied substantially, with the yield moving from 2.60% to 1.60% over a four-month period (September 17, 2014 to January 30, 2015), during which time the Bloomberg Barclays Aggregate returned 4.3%. Besides the 10-year Treasury bond, other high-quality sectors have cheapened enough to warrant a second look. Up-in-quality bonds like municipals, investment-grade corporates, and mortgage-backed bonds are much cheaper now than last year.

Take What The Yield Curve Gives

Plotting the yields of various maturity bonds generates the “yield curve” [Figure 2]. The yield curve is considered steep when the line is upward sloping, with longer yields substantially higher. A flat curve occurs when shorter maturities are closer in yield to longer ones, causing little incentive for investors to buy longer-maturity bonds. As Figure 2 reveals, the yield curve is steep out to 10 years, but flattens from 10 to 30 years. The higher yields in shorter maturities make the decision on where to invest on the curve a less difficult one. Investors need not venture out into the most volatile part of the curve (past 20 years) in order to gain more potential return. The longer maturities do not offer enough compensation to take on the additional interest rate risk. Why invest in 30 years at 3.19%, when the 10-year part of the curve is offering 2.61%? The same type of analysis can be made when focusing on five years relative to 10 years. At a 2.14% yield, the five year is at its cheapest level since 2011, and investors only sacrifice 0.47% of yield by staying shorter, relative to the 10-year maturity. Our baseline scenario for the Treasury curve is for higher interest rates without a big flattening move. In this scenario, investors can take what the curve is giving by targeting shorter-duration bonds in the 5-10 year part of the curve. Shorter maturities can also be used for liquidity if the market becomes volatile. Owning a 10-year bond is a lot less risky than a similar quality 30-year bond if interest rates continue to rise.

Higher Yields Maturities

Let Scenario Analysis Decide

It is difficult to determine yield curve positioning without a firm opinion on the direction of interest rates. One way to begin to formulate this opinion is to focus on hypothetical return scenarios. By comparing a short-term bond profile versus an intermediate-term profile and stress testing them for interest rate changes, we can see which maturity could potentially perform best [Figure 3]. Our analysis compares total returns for the Bloomberg Barclays 1-3 Year Government Bond Index (shorter-term index comprised of government and corporate bonds) against the Bloomberg Barclays Aggregate Index (intermediate-term index). The analysis demonstrates that when interest rates rise by 0.25%, the short-term index outperforms the longer intermediate index by 0.05%. This advantage increases as interest rates rise.

Note that if the opposite occurs and interest rates decline, the scenario analysis clearly favors intermediate bonds. If interest rates remain stable or even fall by 0.25%, then intermediate bonds outperform short-term bonds by 1.0% in an unchanged scenario and 2.05% in the lower-rate environment. Considering that the Fed is telegraphing at least two additional rate hikes this year, lower rates are less probable and prices have come down on short-term bonds, so investors can play it relatively safe in more liquid, short-term bonds without sacrificing much yield.

Higher Yields Maturities

Conclusion

We expect the roller coaster ride in fixed income may continue throughout 2017. Prices have cheapened and the front end of the yield curve has adjusted to the increased volatility driven by the Fed rate hikes and now offers considerable risk/reward benefits. As such, we continue to favor more defensive fixed income curve positioning in the 5- to 10-year part of the curve with neutral- to short-benchmark interest rate sensitivity. Within high-quality fixed income, a diversified allocation to various sectors, including investment-grade corporates and mortgage-backed securities, remains our preferred approach for riding out the volatility of rising interest rates.

Article by LPL Financial