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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What is Smart Beta?

You’ve undoubtedly heard this term, used to describe a certain type of investment that is becoming increasingly popular. What does it mean? And if these investments are “smart,” does that mean that the others are “dumb?”

So-called “smart beta” investing is a bit of an active/passive hybrid methodology. Traditional passive investments are typically replicas of well-known market capitalization-weighted indices, like the S&P 500. A market cap-weighted ETF holds each company in the index according to its size in the index, which can be calculated by multiplying a company’s outstanding shares by the current market price of one share. While this provides broad market diversification at a very low cost, one drawback of this approach is that the companies whose stock prices are rising become relatively larger while companies whose stock prices are falling become relatively smaller. If markets are less than perfectly efficient and stock prices are anything other than fairly valued, cap-weighted indices will tend to favor overvalued companies.

“Smart beta” strategies use different weighting schemes to construct a portfolio, involving metrics such as dividends or low volatility, or even equal-weighting, all of which sever the link between price and weight and tend to provide a value tilt to the portfolio. The reason for this is that, when rebalancing the portfolio, these strategies result in buying low and selling high. Portfolios based on market cap-weighted indices will often do the opposite when rebalancing, buying more shares of the companies whose stock prices are going up, and vice-versa. According to Research Affiliates, LLC, “smart beta” strategies must also encompass the best attributes of passive investing, such as transparency, rules-based methodology, low costs, liquidity, and diversification.

Does this mean that “smart beta” is a panacea that will bridge the gap between active and passive investing? Many of these strategies have back-tested well and have become increasingly popular, resulting in large inflows of capital. Rob Arnott, one of the pioneers of smart beta at Research Affiliates, has written about rising valuations in smart beta investments as a result of their soaring popularity (“How Can “Smart Beta” Go Horribly Wrong?”). He cautions against “being duped by historical returns” and advises investors to adjust their expectations for future returns to account for mean reversion. He and his co-authors think there is a possibility of a smart beta bubble in the works, due to the rising popularity of such strategies.

And what about traditional passive investments? Is there still room for these vehicles in an investor’s portfolio? Absolutely, particularly in the more efficient sectors of the broad market.  Even Arnott believes “there is nothing “dumb” about cap-weighted indexing.” At Parsec, we stay abreast of current investment trends, but use a measured approach to portfolio construction that is research-based and backed by sound financial theory. We don’t believe any one investment is particularly “smart” or “dumb,” but rather that there is room for different types of investments within the context of a well-diversified, well-constructed portfolio.

Sarah DerGarabedian, CFA
Director of Portfolio Management

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High-Yield Turbulence

You may have read some scary headlines on high-yield bonds recently.  We’d like to take a moment to update you on the situation and provide our perspective.  First a little background.  High-yield bonds are debt securities issued by companies with credit ratings below investment-grade.  These bonds are commonly called “junk bonds” because of the weaker balance sheets and growth prospects of the companies that issue them.  As a result of increased default risk, investors typically demand higher interest rates on these types of bonds to compensate for the additional risk they take on.  When things are going well, high-yield or junk bonds can deliver above-average interest payments and price appreciation.  When things are not going well, investors can experience sharp price declines and some companies may even default on bond payments.  In a nut shell, higher reward comes with higher risk.

Many advisors, including Parsec, include a modest amount of high-yield bonds in client portfolios.  Junk bonds are considered an asset class and can improve the diversification of a portfolio because they have lower correlations to regular bonds and even stocks.  This means when regular bonds are flat or down, high-yield bonds could actually rise.  The same goes for stocks – high-yield bonds and equities do not always move in the same direction, which confers some diversification benefits.

In addition to diversification benefits, junk bonds have historically delivered healthy returns.  The group tends to do well in the early years of an economic expansion when tight credit starts to loosen and company balance sheets improve.  On the flip side, high-yield bond performance becomes more volatile as an economic expansion starts to slow down and the spread between higher-quality bonds and junk bonds widen.  This indicates investors once again require more return to hold these higher-risk assets.

Earlier this year, interest rate spreads – the difference between high quality bond interest rates and low quality or “junk” interest rates – started to widen as energy company profits came under pressure and debt default rates ticked higher.  Since May 2015 through mid-December, high-yield bond prices have fallen over 12%*.  However, on a total return basis, the group is down about 8% as higher coupon payments were a partial offset.  While debt default rates on speculative-grade companies are below the 20-year average of 4.3%, at around 2.8%, they’ve jumped from 1.4% a year ago due to falling commodity prices that negatively affect profits**.

As high-yield returns tumbled over the summer, many investors ran for the exits.  Unfortunately, diminished bond liquidity following the 2008-2009 financial crisis made redeeming shares difficult for some.  Regulations that strengthened the banking and financial systems via higher capital requirements and reduced leverage have had the unintended side-effects of raising costs for banks and primary dealers to hold fixed income inventory.  With lower inventory levels, these critical market makers are less able to provide liquidity in the debt markets.  This was highlighted recently when investment firm Third Avenue froze investor redemptions in its high-yield fund (which is not a Parsec holding) due to liquidity constraints.  The Third Avenue fund was heavily invested in some of the lowest-ranked credit bonds, which exacerbated the management team’s ability to find willing buyers.  In the end, Third Avenue chose to freeze investor redemptions for one month.

The Third Avenue situation is unusual, but does it reflect deeper issues for the high yield space?  Our view is that current U.S. economic expansion is maturing, which suggests higher credit spreads and potentially more volatility (including downside risk) for the group.  At the same time, falling commodity prices and a strong dollar are headwinds for high-yield.  That said, U.S. jobs growth remains robust, the housing market continues to advance, and consumers are the healthiest they’ve been since before the Great Recession.  The recent Federal Reserve interest rate hike echoes our sentiments that the U.S. economy is on healthy footing.

While high-yield may see more downside, we believe investors are becoming more discerning after years of indiscriminate investing across high and low-risk asset classes alike.  This is a good thing.  It means that fundamentals, and not accommodative monetary policy, will once again drive asset returns.  Although high-yield bonds may face more headwinds in the near-term, our focus on higher-quality, higher-liquidity, high-yield debt should help us better weather a difficult environment.

Despite potential high-yield headwinds, we continue to recommend that clients remain fully invested.  This is based on our experience that market timing is a losing game, as asset class leadership can change sharply, and often without warning.  The historical record has shown that through various market cycles, both stocks and bonds have out-paced inflation over the long-term.  As a result, we recommend investors stick with their high-yield holdings.

*The BofA Merrill Lynch US High Yield Index

**S&P 500 data

Carrie A.  Tallman, CFA

Director of Research

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