What a Rising Rate Environment Could Mean for Bond Funds

After the yield on the 10-year U.S. Treasury Bond – a widely used economic bell weather – bottomed in July 2016, interest rates have risen substantially through March of this year.  The recent upward pressure on yields has pushed bond prices lower.  Strong economic growth, ongoing interest rate hikes from the Federal Reserve, and recent political developments could mean higher yields ahead.  Given the current environment, we’d like to take a closer look at bonds and bond funds.  We’ll examine how they work, a key risk metric to consider, and how these investments might perform if interest rates continue to rise.

Bonds are a type of fixed income investment given the regular cash flows a bondholder receives.  Similar to your home mortgage but with the roles reversed, investors who own bonds are loaning money to an entity (usually a corporation or a government) in exchange for a variable or fixed interest rate over a specified period of time.  This interest rate is known as the bond coupon and it varies based on the credit worthiness of the entity and the length of the payback period, among other factors.

While a bond’s coupon rate, or its stated yield at issuance, remains fixed for the life of the bond its price or value on the open market will vary based on prevailing interest rates.  When interest rates rise, bond prices fall, and when interest rates fall, bond prices rise.

How sensitive a bond’s price is to a change in interest rates is measured by a term called duration.  Specifically, duration is a measure of interest rate risk.  It indicates how much a bond’s principal value will rise or fall due to a change in interest rates.  Measured in years, a bond or bond fund with a higher duration will be more sensitive to changes in interest rates than a lower duration bond or bond fund.  As a result, a portfolio of bonds with a higher duration will fall more in price as interest rates rise than a portfolio with a lower duration, all else being equal.  Fortunately, bond mutual funds or ETFs report their portfolio duration and investors can use this metric to gauge short-term risk.

I say short-term risk because while a jump in interest rates – as we’ve seen recently – will weigh on a bond fund’s near-term performance, the higher current income that comes as a result of an increase in interest rates will often offset much of the decline in a bond fund’s value over the long-term.  This is one benefit of owning multiple bonds or a fixed income fund versus an individual bond.  Because a portfolio of bonds or a bond fund doesn’t have a single maturity date (instead it contains many bonds with different maturity dates), it can provide more income flexibility.  For example, in a rising rate environment, as some bonds in the portfolio mature, the manager can reinvest proceeds from those securities into new bonds that now have higher yields.  In turn, this pushes the portfolio’s yield up and helps to offset price declines.  In particular, bond funds can offer significant diversification benefits given their exposure to many individual bonds with different durations and credit profiles often for a low fee.

While a bond fund’s duration will indicate how much it declines (or rises) in price when interest rates rise (or fall) over a given period, it also indicates how much of a boost it will get from new, higher yields.  Bond funds with higher durations – which are more sensitive to interest rates – typically offer higher current yields to compensate for their higher risk profiles.  So while bond portfolios with higher durations will experience sharper price declines when interest rates rise, they’re also more likely to benefit from higher current income over the long-term.  At the same time, bond funds with shorter duration – which are less sensitive to interest rate changes – won’t benefit as much from higher current income associated with rising interest rates, but they won’t fall in price as much either.

The point is that bond duration is a useful risk metric.  When a fund has a higher duration it tells us that its price will fall more dramatically when interest rates rise as compared to a lower duration fund, but it should benefit more from higher current income tied to higher yields.  The key, however, is your investment time-horizon.  As an investor, you’ll be able to benefit from the higher current income of a longer duration bond fund only if your time-horizon exceeds the fund’s duration.  When it does, higher income over the long-term should offset near-term price declines.

This dynamic – of higher income offsetting falling bond prices – is related to the nature of bonds and is nicely illustrated by the Bloomberg Barclays U.S. Aggregate Bond Index.  According to Charles Schwab, since 1976 over 90% of this index’s total return has come from income payments rather than price changes.

While most investors should fair well with a bond fund that is aligned with their investment horizon, diversification is another important consideration.  As stocks have historically delivered the strongest long-term returns and have outpaced inflation since the early 1900’s, bond investments are best used when there is a specific income need.  When this is the case, having a mix of shorter and longer-duration bond funds can help an investor take advantage of a changing interest rate environment and mitigate sharp price swings.  In today’s environment, owning bond funds with varying durations – in proportion to one’s income needs, investment time horizons, and risk tolerance – an investor should be better able to take advantage of rising interest rates.  For example, let’s take a client with 20% of his bond holdings in a short duration fund, 20% in an intermediate duration bond fund, and 60% in a long duration bond fund.  If interest rates were to rise sharply, the lower duration fund would see a small if negligible decline in value. In some cases, it may make sense for the investor to sell some of those shorter duration securities and use the proceeds to add to their long duration bond fund, which would now have a higher current yield.

In addition to duration and price sensitivity, Parsec’s Research Committee considers many other factors when constructing a client’s fixed income portfolio.  We also look at where we are in the credit cycle, the underlying quality of each bond asset category, valuation levels, and inflation sensitivity, among others.  Although thorough and well thought out research is critical to meeting your financial goals, staying invested for the long-term is even more important.  When appropriate, doing so with a fixed income portfolio can help you better weather significant price swings and ultimately benefit from current income.

Thank you,

The Parsec Team

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34th Annual Crystal Ball Seminar

We are excited again to co-sponsor the 34th Annual Crystal Ball with the University of North Carolina at Asheville. This has been a long-standing tradition that we look forward to every year.

On May 3, economists David W. Berson and James F. Smith will make forecasts on the business and financial outlook for the coming year and will explore the implications of those predictions on a state, national, and international level.

To learn more about the speakers and the presentation, please visit the crystal ball website:

https://events.unca.edu/event/34th-annual-economic-crystal-ball-seminar

EVENT DETAILS

Speakers:
David W. Berson of Nationwide Insurance
James F. Smith of Parsec Financial

Location:
Lipinsky Hall Auditorium – UNC Asheville campus

Date:
Thursday, May 3, 2018

Agenda:
6:15 PM – Reception with light hors-d’oeuvres & refreshments
7:00 PM – Economic Outlook
7:30 PM – Financial Outlook
8:00 PM – Q&A

Admission is free, however, seating is limited. To register, contact UNC Asheville’s Economics Department at 828.251.6550 or email kmoore@unca.edu.

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Are We Heading Towards a Recession?

The stock market is considered one of several leading economic indicators. Since 1949 markets have turned lower on average seven months prior to recessions, with a median pullback of about 9%.  However, this includes a wide range of numbers and in six out of the last nine recessions stocks were actually positive for the preceding twelve month period. Recently, investors’ recession fears have jumped in light of increased market volatility. While these concerns are understandable, we prefer to take a broader view when gauging the health of the U.S. economy. Doing so suggests more factors are working in favor of the current expansion than against it, and we could have more room to run.

As of March 1st, the United States entered its 105th month of economic expansion – the third longest on record. If gross domestic product (GDP) remains positive through May, the current expansion will become the second longest in U.S. history. While subpar growth has helped extend the length of this economic cycle, it’s important to acknowledge that we are likely in the later innings of the expansion that started in 2009.

Despite its unusual length, our economy has several factors working in its favor. These include strong corporate earnings growth, a healthy consumer, and improving business spending. Corporate earnings have improved significantly following a decline in 2015 that was tied to lower oil prices and an appreciating U.S. dollar. Likewise, the recently passed tax law — which reduced the U.S. corporate tax rate from 35% to 21% — should provide a significant boost to corporate spending in the months and years ahead. In fact, we’ve already seen a pick-up in capital expenditures from businesses as they’ve been able to return more cash held abroad at lower tax levels.

Although business spending has been notably weak for most of this economic cycle, the consumer has been a major contributor to GDP growth since 2009 and remains healthy. Strong jobs growth and recent gains in wage growth should continue to support household spending. While markets are concerned that the recent gains in wage growth suggest inflation may be heating up, it’s important to remember that for the last nine years investors were more worried about deflation. We would suggest the recent increases in wage growth reflect a healthy development, one that indicates a return to more normal conditions.

To that point, U.S. inflation has been persistently below the Federal Reserve’s 2% target since the Financial Crisis.  With the recent uptick in wage growth, the Personal Consumption Expenditure Index (PCE) – what the Fed uses to track inflation – is now up only 1.7% on a year-over-year basis.  Contrary to investor concerns, this would not suggest an over-heating price environment but a return to healthy inflation levels. Gradually rising inflation will also allow the Federal Reserve Open Markets Committee (FOMC) to continue to normalize interest rates, which have been at unusually low levels. Higher yields will help support millions of retirees on fixed incomes, stabilize many pension funds, and most importantly give the FOMC wiggle room to lower rates when the next downturn occurs.

As the FOMC continues to raise rates this year, investors and economists will be closely monitoring the yield curve. The yield curve is a line that plots the interest rates of bonds with the same credit ratings but different maturities. During economic expansions, the yield curve is usually upward sloping as bonds with longer maturities typically have higher yields. However, since 1901 there have been seventeen inverted yield curves (when the yields on shorter maturity bonds exceed those on longer maturity bonds) that have persisted four months or longer, all of which have been followed by a recession. Thus, an inverted yield curve that stays inverted for at least four months has never produced a “false positive” recession reading. This stands in contrast with the stock market, which as the late Nobel laureate Paul Samuelson once said, “has accurately predicted 9 of the last 5 recessions”.

Towards the end of 2017 the yield curve began to flatten. This caused some investors to worry it would invert, indicating a recession was around the corner. Starting in late January stock market volatility and bond yields jumped, amplifying investors’ recession fears. Ironically, the stock market turbulence and higher interest rates helped push the yield curve higher. Although the recent market swings and decline in bond prices (resulting from higher yields) were unpleasant, they are helping to avoid an inverted yield curve – one of our most reliable recession predictors.

In short, we see more positives than negatives regarding the economy. At the same time, it’s evident that we are in the later innings of the current expansion and risks such as high corporate debt levels, rising interest rates, and above-average asset valuations could trigger the next recession. Accurately predicting when that will happen, however, is a difficult job for even the most astute economists and investors. Fortunately when looking at the prior nine recessions since 1957, stocks have declined just 1.5% on average and market returns one-, three-, and five-years following past recessions have been significantly positive. Granted, the stock market during any individual recession may be significantly negative, but in four out of the last nine recessions, stocks actually rose. These statistics support our belief in long-term investing and using market pullbacks as opportunities to add to positions at lower prices.

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Implications for “Brexit”

Investors received surprising news this morning, as the United Kingdom (U.K.) voted to leave the European Union (EU).  While markets will no doubt experience increased volatility in the coming weeks, longer-term, we believe the negative impact of “Brexit” will be largely contained to Great Britain and Europe.

Trade accounts for about 40% of the U.K.’s gross domestic product (GDP), with most of those exports and imports tied to EU partners.  As a result of the recent vote, Britain is likely to see higher trade tariffs from the EU and more trade staying within continental Europe’s borders.  Both of these shifts could weigh significantly on Britain’s economic growth in the mid-term and would likely weigh on EU growth as well.  One positive is that the U.K. never adopted the Euro, choosing instead to maintain the British Pound as its currency.  This is should make an exit from the EU smoother and slightly less costly than if they had converted to the Euro, and suggests it could be less detrimental than if Greece had left.

While the U.K. is likely to experience the largest negative impact by leaving the EU, continental Europe is also at risk given its relatively fragile economic expansion following the Financial Crisis of 2008-2009.  From 2010 through 2015, EU GDP has grown at an average rate of just 1.2% compared to U.K. GDP growth of 2.0%.  Thus any major shock, such as one of its strongest members leaving the Block, could derail those modest growth levels.

Turning to the U.S., Europe is one of our larger trade partners with about 16% of total U.S. exports going to the Block last year.  This is not an insignificant number, and will likely weigh on U.S. GDP growth in the near-term.  However, the U.S. consumer remains the largest driver of our economy, accounting for about two-thirds of GDP growth.  Following the Financial Crisis of 2008-2009, the U.S. consumer has gotten healthier, supported by an expanding housing market, strong jobs growth, and deleveraging.  A resilient consumer and relatively better economic growth compared to the rest of the world should position us to better weather the recent developments in Europe.

To be sure, today’s news surprised investors and markets alike.  Although the near-term economic impact will likely be limited to the U.K. and Europe, the vote has broader implications for the future of the European Union.  While we can’t predict the longer-term repercussions of today’s historical vote, we can assure you of the benefits of staying invested in a diversified portfolio over the long-term.  Markets will experience sharp corrections, as well as strong rallies, yet clients who remain invested across asset classes throughout the market cycle have a better chance of reaching their financial goals.  With this perspective in mind, market declines like the one we’re seeing today simply represent an excellent opportunity to rebalance your portfolio at more attractive valuations levels.

 

Thank you,

The Parsec Team

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