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1 Fall 1 Documeent title on one or two Positioning lines in Gustan bond Book portfolios pt for rising interest rates Stephen MacDonald, CFA Managing Director Client Portfolio Management Peter Moore Director Client Portfolio Management Four factors to consider in designing an effective fixed-income strategy The prospect of rising interest rates comes into focus As the U.S. economy continues on its steady, moderate growth trajectory and the Federal Reserve s third wave of quantitative easing (QE) asset purchases comes to an end, a question at the forefront of investors minds is how to position portfolios for the rise in interest rates that is likely to follow. Predicting the timing and scope of an eventual increase in rates is not an easy task, as Fed and global central bank QE programs have distorted the patterns of demand for many types of fixed-income securities, creating a market that has been driven as much by technical as by fundamental factors. In the wake of the global financial crisis and recession of 7 9, Fed policy expanded well beyond its traditional focus on influencing short-term interest rates via the target federal funds rate, which has been maintained at nearly % since December 8. Through aggressive, open-market asset purchases (including three waves of QE), the Fed s influence has extended to medium- and long-term interest rates as well, including the bellwether 1-year U.S. Treasury yield (Exhibit A). The end of the Fed s substantial QE purchases of Treasuries and other fixed-income holdings will certainly have a bearing on the market interest rates on these securities, with the likely effect being higher rates than what would be expected under unprecedented stimulus. Exhibit A: Quantitative easing has kept rates low 1-year Treasury yield, daily closing values, 199 1* 9% QE1 QE QE Between late October 8 and the end of 1, the 1-year Treasury yield fell basis points, from % to 1.78%, with a record-low close of 1.% on July 5, 1. hile the 1-year yield subsequently climbed in 1, closing just above % at the end of the year, it has resumed its decline in 1. Given the U.S. economy s continued moderate strengthening and the final tapering of the Fed s QE asset purchases, this prolonged period of low interest rates is poised to end. * Through October 1, 1. Source: U.S. Treasury Department.
2 Because current market conditions differ from those in previous periods when interest rates rose, it is difficult to get a sense of what to expect in a rising rate environment by looking at past experience alone. Still, investors can better prepare for the eventuality of higher rates by understanding the various ways in which different types of fixed-income securities and investment vehicles may respond when rates rise, and by understanding the dynamics shaping the composition of today s fixed-income markets. Additionally, before making asset allocation decisions to protect against rising rates, investors should carefully evaluate alternatives to fixed-income investments particularly with respect to the possible effects these substitute investments may have on a portfolio s risk-adjusted performance. Four considerations for fixed-income investors In the pages that follow, we identify four factors that we believe will be essential to a successful fixed-income strategy in the rising rate environment to come. 1. Diversification matters. Different types of fixed-income securities respond differently to rising rates Sensitivity to interest-rate movements can differ substantially based on duration, credit quality, and type of security. In general, corporate bonds (both investment-grade and highyield) floating-rate notes, emerging-market debt, shorter-term issues, and certain types of structured securities may provide greater protection from losses during periods of rising rates. In such environments, spreads between Treasury yields and yields on lower-rated, higher-yielding securities tend to narrow. This is largely because improving economic conditions typically lead to lower expected default rates for non-treasury products, making them a potentially better relative value with a more favorable risk/reward tradeoff than Treasuries. For example, in 9, interest rates increased sharply, with the yield on the bellwether 1-year Treasury note climbing from.6% to.85%. As shown in Exhibit B, longer-term, higher-rated bond sectors tended to lag during this period, while shorter-term, lower-rated, and securitized assets outperformed. In some cases, the disparity in performance among categories was dramatic, underscoring the value of diversification. Exhibit B: Fixed-income performance may vary when interest rates rise In 9, as interest rates rose...lower-rated credits outperformed...short- and intermediate-term categories beat longer maturities % 1.91 Aaa 8.9 Aa 15.1 A 7.9 Baa 7% U.S. Aggregate.8 1 Yrs 5 Yrs 5 7 Yrs 7 1 Yrs 1 Yrs or higher...high-yield, emerging-market and investment-grade corporate bonds dominated other sectors 6% Treasuries (+ yrs) Treasuries Agencies Mortgage-backed Floating-rate Corporate Global emerging High yield Source: Barclays. Total returns for all categories shown are based on the respective components of the Barclays U.S. Aggregate Bond Index except as follows: U.S. floating-rate notes (Barclays U.S. Floating Rate Notes Index); global emerging markets (Barclays Global Emerging Markets Index); and high yield (Barclays U.S. High Yield Index). It is not possible to invest in an index. Index performance does not reflect investment fees or transaction costs.
3 A more recent example came in 1, when credit spreads were much tighter than in 9. The 1-year yield began 1 at 1.78% and finished the year at.%. Again, returns for fixed-income sectors varied widely in this rising rate environment, albeit somewhat differently than in 9. Nonetheless, with returns ranging from -1.66% for longterm U.S. Treasuries to.% for commercial mortgagebacked securities to 7.% for high-yield corporate bonds, the rationale for diversifying across sectors held true.. Active management may offer advantages over indexing. Greater flexibility can help mitigate interest-rate sensitivity In the past several years, public debt has crowded out private debt. For bond indexing strategies, the result has been much greater representation of Treasury securities, longer duration, and heightened sensitivity to interest rates. As shown in Exhibit C, since the Great Recession, the Treasury sector weighting in the Barclays U.S. Aggregate Bond Index has grown from 5.1% to 5.5% largely due to increased issuance by the U.S. Treasury based on large fiscal deficits over that period. Corporate bonds have also grown as a share of the index (albeit to a lesser degree), with companies taking advantage of low rates to refinance debt, extend maturities, and change their debt mix to reduce their cost of capital. Meanwhile, securitized assets, including mortgage-backed securities (MBS), commercial mortgage-backed securities (CMBS), asset-backed securities (ABS), and other structured securities, decreased between 8 and 1. This decline reflects curtailment of private label (non-agency) MBS issuance because of credit quality concerns following the subprime mortgage crisis, along with diminished MBS supply due to more stringent underwriting standards from issuing agencies. These market dynamics have resulted in steadily growing demand for a shrinking supply of spread sector products (higher-yielding, non-treasury debt instruments), as fixedincome investors seek securities that represent compelling relative value, generate sustainable income, and are likely to be more resilient under a range of economic circumstances. Identifying such opportunities requires a careful, discriminating approach to security selection which tends to favor active managers. Compared with indexed portfolios, actively managed portfolios have greater flexibility to avoid the increased exposure to interest-rate risk currently reflected in broader market indexes. Accordingly, fixed-income investors may be better served by choosing active portfolios with a proven record of diversified sector allocation and effective security selection. It is also important to remember that actively managed strategies can take advantage of yield curve dynamics in order to mitigate the risk of rising rates. For example, given the steepness of the yield curve today, strategies that can benefit from roll-down (or price appreciation as a bond approaches maturity, assuming an upward sloping yield curve) and appropriate positioning along the curve may be rewarded. Exhibit C: Benchmark composition has changed Sector weightings in Barclays U.S. Aggregate Bond Index show growth in Treasuries as of 1/1/8 as of 9//1 1.5% 5.7% 9.7% 5.5% 1.5% Treasury Corporate Securitized (MBS, CMBS, ABS, other) Other.7% 17.67%.% Source: Barclays
4 . Interest-rate increases and potential market declines will likely be moderate. History offers some perspective on interest rates and market performance hile fixed-income losses due to rising interest rates present a risk, corresponding market fears may be disproportionate to the severity and lasting impact of the losses actually incurred. Such fears are based partly on exaggerated expectations for the scope of future rate increases. After months of market anxiety, varying interpretations of Fed guidance, and a 1 taper tantrum, it now appears that the end of QE along with the eventual onset of short-term rate hikes is largely priced into the market. Moreover, with the U.S. economy experiencing virtually no inflationary pressures, we think any coming rise in long-term rates is likely to be moderate and gradual. An increase of 1% to % in the 1-year Treasury yield, for example, would represent our base case scenario, occurring gradually between late 1 and the end of 16. In our view, the U.S. economy is far enough along in its recovery to withstand such a move. However, we also recognize that some risks to the recovery remain including markedly slower growth in Europe and China, which, combined with a stronger U.S. dollar, could dampen global demand for U.S. exports. Decelerating growth outside of the U.S. has already influenced the global interest-rate environment, which currently looks different than what we have seen in previous cycles. Ten-year yields are now higher in the U.S. than in Europe and most other major developed markets. This could help mute the scope of coming rate rises in the U.S. Assuming at least a mild to moderate rate increase is on the horizon, it s natural to try to anticipate its likely impact. e can look to history to see how fixed-income markets have performed when rates were rising, recognizing that the past may provide useful context but is not a predictor of future outcomes, as economic and market conditions are never identical. Indeed, the lack of historical precedent for the degree of market support that has been provided through the Fed s QE programs and uncertainty as to how credit markets may respond after this support is withdrawn make it particularly challenging to gauge the likely impact of forthcoming interest-rate changes. ith that cautionary note in mind, our analysis shows that bond markets have tended to be resilient, bouncing back after initially incurring losses during rising rate environments. For example, based on previous periods when the 1-year Treasury yield was low (less than.5%) but increasing, intermediate-term government bonds realized losses of 1% % over one-year time frames. As illustrated in Exhibit D, however, these short-term losses reversed over medium-term time frames. Exhibit D: Bond markets have shown resilience following rate increases Intermediate-term government bonds 1-year and rolling -year total returns since year return Rolling -year return % hat happens when rates rise sharply from low levels? Since 196, there have been three years 191, 1958, and 9 in which long-term interest rates started below.5% and jumped by at least 5 basis points (.5%) over the course of the year. In those years, intermediate-term government bonds posted losses of -.%, -1.9% and -.%, respectively. However, those one-year losses reversed relatively quickly. Three-year returns (encompassing the current year and the subsequent two years) for 191, 1958 and 9, were.67%,.19% and.6%, respectively. In fact, as shown in this graph, despite 1 instances of negative one-year returns since 196, average annualized returns for intermediate-term U.S. government bonds have been positive over all rolling -year periods. Of course, past performance is no guarantee of future results, and there is no assurance that bonds will perform similarly if interest rates rise sharply from current levels. Source: Ibbotson Associates. Performance reflects the Ibbotson Associates Stocks, Bonds, Bills, and Inflation (SBBI) US Intermediate-Term Government Total Return USD index. It is not possible to invest in an index. Index performance does not reflect investment fees or transaction costs.
5 In fact, average annualized returns for intermediate-term U.S. government bonds have been positive for all rolling three-year periods since 196. There is no guarantee that fixed-income markets will repeat this pattern of short-term reversals in the next interest-rate cycle. Nonetheless, in the long run, the risk of being underexposed to fixed income due to market timing may outweigh the risk of exposure to rising interest rates. Investors who maintain a longer-term focus and resist the impulse to react to short-term volatility are more likely to benefit from the positive returns of fixed income assets over time.. Alternatives to fixed income may carry unintended risks. Finding viable substitutes for bonds is sometimes easier said than done Fixed-income investors seeking to avoid the negative impact of rising interest rates may be tempted to reallocate assets to income-generating investments such as high-dividend stocks, real estate investment trusts (REITs), or opportunistic, unconstrained bond portfolios. hile these substitute investments can offer attractive return and diversification opportunities in their own right, they generally have risk profiles, concentrated exposures, or other characteristics that differ greatly from those of a traditional bond investment, making them potentially unsuitable alternatives. In addition, some of these asset classes have themselves benefited from the artificially low interest-rate environment that has prevailed since the onset of QE, and may also be susceptible to sharp losses when the Fed s asset purchases end. The benefits and risks of such alternatives are not identical to the characteristics of typical bond holdings. Investors need to consider whether and to what extent they should adjust their fixed-income allocations using these or other types of assets. Conclusions The prospect of higher interest rates is real, although the likelihood of extreme shifts leading to steep bond-market losses may be tempered by a lack of inflationary pressures, the ability of the U.S. economy to absorb at least a moderate rate increase, and the extent to which the market has already priced in rising rates. Against this backdrop, fixedincome strategies can differ substantially in the degree of protection they may offer in a rising rate environment. Investors who maintain diversified, actively managed exposure to a range of fixed-income securities over medium-term time frames will likely be better positioned to withstand the potential impact of rising interest rates than investors with index-like or more concentrated exposures. Due to the lack of viable fixed-income alternatives and uncertainty of market-timing strategies, investors are often better served by maintaining consistent, strategic exposure to fixed income over time rather than opportunistically rotating among equity, fixed income, and other asset classes. Moreover, asset classes intended to serve as substitutes for fixed income may themselves be vulnerable to risks resulting from the unwinding of QE. Investors who are inclined to reduce their overall fixedincome allocation because of interest-rate concerns should do so judiciously, positioning their remaining exposure with an emphasis on diversification, active management, and a long-term perspective. Despite the vulnerability of bond valuations to rising interest rates, we think fixed-income exposure can continue to play a useful role in our clients portfolios, if managed effectively. A fixed-income strategy that considers the issues and perspectives explored in this paper may provide the basis for navigating what will undoubtedly be a challenging environment. Visit us at for additional information about TIAA-CREF s fixed-income capabilities. This material is for informational purposes only and should not be regarded as a recommendation or an offer to buy or sell any product or service to which this information may relate. Certain products and services may not be available to all entities or persons. Past performance does not guarantee future results. Investments in fixed-income securities are not guaranteed and are subject to interest rate, inflation, and credit risks. provides investment advice and portfolio management services to the TIAA-CREF group of companies through the following entities: Teachers Advisors, Inc., TIAA-CREF Investment Management, LLC, and Teachers Insurance and Annuity Association (TIAA ). Teachers Advisors, Inc., is a registered investment advisor and wholly owned subsidiary of Teachers Insurance and Annuity Association (TIAA). 1 Teachers Insurance and Annuity Association of America-College Retirement Equities Fund (TIAA-CREF), 7 Third Avenue, New York, NY 117 C9 81_7867 A167 (1/1)
interest-rate environment
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