Managing Bonds When Interest Rates are Rising
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Fixed Income Portfolio ManagerTweet this article
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“Investors with a longer-term horizon should view rising rates positively because they create opportunity for higher income and, ultimately, higher returns.”
“Higher interest rates may be coming.” That was the forecast we shared on these pages one year ago. Our forecast was based on expectations for higher inflation in the near term and changing demographics over the longer term. Since that time, the Federal Reserve has raised the target for the federal funds rate (an overnight lending rate) by 0.5% and the yield on the 10-year U.S. Treasury bond has risen from 1.8% to 2.4%.
Inflation was in fact the driver behind higher interest rates this past year. As shown in Figure 1, the year-over-year change in the U.S Consumer Price Index (CPI) jumped from just 1.0% last February to 2.7% currently. Yields on U.S. Treasuries rose with the CPI.
Our current forecast calls for further interest rates increases on shorter-maturity bonds. This is primarily due to the Federal Reserve’s projections for two more federal funds rate increases in 2017, on the way toward normalizing the rate at 3% by 2019. Interest rates on longer-maturity bonds, however, may stall in the near term. Energy prices, large contributors to the recent spike in inflation, are flattening on a year-over-year basis. As a result, the CPI will likely move lower in the months ahead. Bond investors are anticipating this near-term drop in the CPI level, as evidenced by the yield on the 10-year U.S. Treasury bond being lower than the CPI. Nevertheless, our longer-term forecast that changing demographics will push interest rates higher across all maturities is still in place.
What Do Rising Rates Mean for Bond Investors?
Because bond prices fall when interest rates rise, bond investors tend to view rising rates negatively. Investors with a longer-term horizon, however, should view rising rates positively because they create opportunity for higher income and, ultimately, higher returns. But to benefit from rising rates you must position your bond portfolio appropriately. This is done by structuring the portfolio to participate in the rise in rates while limiting the price declines that rising rates cause.
Participating as Interest Rates Rise
Participating as interest rates rise is about capturing the increasing levels of bond income that higher rates provide. To do so successfully requires that you design a portfolio with the proper maturity structure. This requires a balancing act.
At one extreme you could simply hold cash or money market instruments while waiting for higher rates. This strategy provides maximum flexibility and avoids having money locked in at current interest rates. However, this strategy can prove costly due to the lower income you will earn while waiting relative to what you could have earned on longer-maturity bonds. This is especially costly if higher interest rates do not arrive as soon as anticipated. One only needs to look back at the past eight years of near zero money market rates for evidence of that.
At the other extreme, if you invest in longer-maturity bonds you will be locked in at current interest rate levels and you will not be positioned to participate as rates rise. This strategy also exposes you to greater price declines as we discuss below.
In sum, you need a Goldilocks portfolio—one that is neither too short, nor too long in maturity. It is a portfolio that is just right. To us this currently means a portfolio with maturities out to seven years, in order to capture much of the income available, but with a concentration of one-to-three year maturities that allow for reinvestment at higher rates as bonds mature.
Limiting Price Declines
We mention above that bond prices fall when interest rates rise. How much a bond’s price changes in response to changes in interest rates is measured by its duration. The main drivers of duration are a bond’s maturity and the size of its interest payments, or coupons. Figure 2 shows how the prices of bonds with different maturities and interest coupons are affected by a one-percentage-point rise in yield occurring over a one-year period.
Maturity plays the largest role as reflected by the difference in total returns between 3-year and 20-year bonds paying the same interest amounts. All other things being equal, the longer the maturity the greater a bond’s price changes in response to interest rate changes. The size of interest coupons has a lesser, but still meaningful, effect as shown by two 10-year bonds with different size coupons. Putting this together makes clear that a combination of shorter maturities and higher interest coupons can limit price declines caused by rising interest rates.
A New Era for Bonds
We believe the 35-year secular period of declining interest rates came to an end this past year. If we are correct, a trend of rising interest rates, briefly interrupted by periodic cyclical declines, can be expected for the foreseeable future. Because bond prices fall as interest rates rise, investors should initially expect a period of lower total returns from their bond portfolios. However, for properly managed portfolios, this period will be followed by higher long-term returns than what could be achieved if interest rates remained low. At Goelzer, we are structuring bond portfolios to participate in the opportunity for higher long-term returns that rising interest rates will bring.