With abnormally low yields over the last few years, investors have been on high alert to the potential impact that an unpleasant end to a 30-plus year bull-run in bonds could have on their portfolios.
With US 10-Year Treasury yields rising over 80bps since the end of April, many investors are now feeling the pain. While other asset classes may offer greater potential for risk-adjusted returns in today’s market, fixed income can and should remain core to investment portfolios due to its potential for income generation, diversification and capital preservation. Fortunately, there are opportunities available for savvy investors to create resilient portfolios regardless of how far and fast rates may rise over the rest of the year.
Bonds under pressure
As the economy continues to recover from the Great Recession and the lingering impacts of the European sovereign debt crisis subside, it comes as no surprise to see rates on the rise. What seems to have caught investors by surprise however, is the speed at which rates moved after Fed Chairman Ben Bernanke suggested that QE may be tapered off sooner than consensus expected. As highlighted in Figure 1, US 10-Year Treasury yields have spiked over the last two months, which introduced greater volatility into the fixed income market. This move has led to negative returns from various segments of the fixed income market as shown in Figure 2.
For investors looking for core exposure to the fixed income market, the Barclays US Aggregate Index (Agg) has been the traditional vehicle of choice. Even after not faring well year-to-date, the Agg offers investors a relatively low yield with increased interest rate risks relative to history, as illustrated by the divergence in yield and duration shown in Figure 3. What is driving this potentially detrimental change? One factor is that the weight of Treasuries in the Agg has increased over the past five years. In isolation, this is not necessarily bad. However, what is disconcerting is that the Agg’s increase in duration can be attributed to the rise in Treasury exposure.
Skeptics may counter with “so what”? The Agg is simply reflecting the US investment grade market as it always has. Exposures will ebb and flow over time. While technically correct, this thinking may add to the risk inherent in today’s market. Fortunately, investors no longer need to think simply about core exposure or core plus to meet their investment needs. Many have already begun to integrate the next generation of fixed income into portfolios on a more consistent basis. Taking this a step further with greater control over exposures will allow for further precision. In other words, investors no longer need to think of allocations across bond market sectors as merely a bolt-on approach.
Solutions for rising rates in today’s market
With corporations maintaining a focus on balance sheet management, firms remain generally healthy today. Leverage ratios are moderate and interest coverage is strong as highlighted in Figure 4. While global economic risks remain slightly skewed to the downside, corporations are benefitting from an environment of improving economic growth with low inflationary pressures. At the same time, a rising US dollar in the near-term may help drive increased consumption, adding further fuel to the tailwinds of a housing recovery and better jobs numbers. Thus, investors should feel comfortable taking on credit risk to meet their income needs. In addition, default rates are expected to remain low over the coming year. By diversifying portfolios across fixed and floating rate investment-grade high-yield securities, investors will be able to construct portfolios that meet their needs in an environment of rising rates.
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