PDF Fixed Income in a Rising Rate Environment - Morningstar, Inc.
Fixed Income in a Rising Rate Environment
With interest rates at historically low levels, fixed income investors have become increasingly concerned about rising rates and how their portfolios might be affected. However, rising rates do not necessarily mean negative total returns for fixed-income investments. While rising interest rates adversely impact bond prices, various asset classes respond differently to rising rates, and active portfolio management can also help mitigate the impact rising rates have on returns. This paper examines the factors that can affect interest rates, as well as how fixed-income investments can respond as rates rise.
THE SPECTER OF RISING RATES With short-term rates at record lows, investors are seeking yield. However, many are cautious in choosing fixed-income investments given the potential for rates to rise as the economy continues to expand. Many investors ask, "How can I best position my portfolio in a rising rate environment?" The answer starts with understanding the relationship between interest rates and fixed-income returns.
MAY 2011 Tony Rodriguez Managing Director, Co-Head Fixed Income
Chris Neuharth, CFA Managing Director, Portfolio Manager
Kari Stanway, CFA Vice President, Client Portfolio Manager
Nuveen Asset Management, LLC
Why Do Interest Rates Rise?
Interest rates reflect the cost of borrowing over time. Many factors impact interest rates, including the real cost of funds; inflation expectations; preference for shorterterm, more liquid securities; investor risk appetite and supply/demand balance.
One of the most visible market indicators of interest rates for many investors is the monetary policy decisions of the Federal Reserve. The Federal Funds rate, which anchors short-term rates in the market, is a key tool in implementing these policy decisions. Typically, the Federal Funds rate is raised to temper inflation as the economy expands. So now that we have experienced some improvement in the overall economy and increasing commodity prices, many investors worry about rising rates.
NOT FDIC INSURED NO BANK GUARANTEE MAY LOSE VALUE
NUVEEN ASSET MANAGEMENT FIXED INCOME IN A RISING RATE ENVIRONMENT
Longer-term interest rates, on the other hand, are fundamentally driven by inflation expectations. Some believe that increases in the Federal Funds rate automatically mean rates go up along the yield curve spectrum, but this is not typically the case. Usually, as short-term rates rise, the yield curve also reshapes itself. A yield curve is a line that plots the interest rates, at a set point in time, of bonds having equal credit quality, but differing maturity dates. Since the current yield curve is historically steep, Nuveen Asset Management (Nuveen) believes that a rise in short-term rates caused by Federal Reserve tightening will result in a flattening of the yield curve, with short-term rates rising more than long-term rates.
Impact of Rising Rates on Fixed-Income Returns Traditional financial theory portends that bond prices fall when interest rates rise. Yet, a bond's total return comprises not just price changes, but also income. This is important because, as rates rise, the income on a bond can help offset falling prices, cushioning the overall total return. For investors, the relevant questions are:
? How much will the price fall?
? Is there enough income to offset the price decline?
Role of Specific Market Conditions Historical analysis is an objective way to understand how fixed-income investments typically respond to rising rates. To simplify the analysis, a rising rate period is when the Federal Reserve is tightening. This means that short-term rates are rising, but other factors may be impacting the intermediate and long ends of the yield curve. Since 1994, there have been three periods of increasing Federal Funds rates. However, each of these periods has had unique factors that impacted the way fixed-income investments responded, as shown in Exhibit I. Let's consider a few of these factors:
? Starting Rate Level ? The absolute rate level is important because the bond's income helps to cushion its total return from price erosion. Higher starting income levels provide more cushion. Currently, starting rates are lower than other historical periods.
? Number, Magnitude and Duration of Federal Funds Hikes ? The speed with which the Federal Reserve (Fed) acts is also important. If they raise rates gradually over a longer period of time, the income on the investment can offset the decline in price. More dramatic increases over shorter time frames make it more difficult for income to compensate for price declines. Nuveen believes that the Fed will take a gradual approach to unwinding accommodation.
? Starting Credit Spread Levels ? Credit spreads are the difference between the yield of a riskless Treasury bond and a security with credit risk, such as corporate bond. At their essence, credit spreads are a risk premium. During periods of economic expansion that cause rates to rise, market risk premiums typically decline. When times are good, investors demand less of a risk premium because they are more confident they will get their money back.
MAY 2011
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NUVEEN ASSET MANAGEMENT FIXED INCOME IN A RISING RATE ENVIRONMENT
MAY 2011
Wider starting credit spread levels have more room to tighten.This helps reduce the overall market yield should spreads tighten. The result is less of a decline in the prices of non-government bonds. However, if credit spreads are tight at the start of the rising rate period, there is little potential offset to falling bond prices. Currently, starting yield spreads are wider than other historical periods.
? Yield Curve Steepness ? A steep yield curve will typically move towards a more normal, gradually upward sloping shape during a period of monetary policy tightening, with short-term rates rising more than long-term rates. This flattening yield curve has less of an impact on the price of longer-term bonds. The current yield curve is much steeper than in other historical periods.
? Other Variables ? Each period has its own specific factors that may help or hurt the total returns of bonds. These may be economic in nature or technically driven.
Exhibit I: Market Conditions during Periods of Increasing Fed Funds Rates
Period 1 2/4/94-2/1/95
Period 2 6/30/99-5/16/00
Period 3 6/30/04-6/29/06
Current Period (starting 3/31/11)
Starting Rate Level1
5.87%
5.78%
4.58%
3.47%
Number of Hikes
7
6
17
?
Magnitude
3.00%
1.75%
4.25%
?
Duration
12 months
10 months
24 months
?
Starting Credit Spread Levels2
72 basis points
120 basis points
101 basis points
142 basis points
Change in Credit Spread Levels2
-4 basis points
+43 basis points
- 8 basis points
?
Yield Curve Steepness3
+200 basis points
+48 basis points
+252 basis points
+368 basis points
Other Economic Variables
? Economy expanding above trend, inflation rising
? Pre-emptive tightening
? Strong economy, full employment, inflationary concerns
?Pre-emptive tightening
? Low inflation, trend-like growth
? Removal of policy accommodation at a measured pace
? Trend-like growth with high unemployment and low inflation
? Tightening will likely be a normalization of policy
Sources: Bloomberg; ; Barclays Capital Live. Data shown applies to the actual time periods noted in the table. 1 Represented by the 10-Year Treasury yield. 2 Yield difference between Barclays Capital Corporate U.S. Investment Grade Bond Index and Barclays Capital U.S Treasury Index. Change in Credit Spread Levels is measured from the beginning to the end of each period. 3 Yield difference between 2-year and 30-year U.S. Treasury securities measured at the beginning of each period.
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NUVEEN ASSET MANAGEMENT FIXED INCOME IN A RISING RATE ENVIRONMENT
MAY 2011
Impact on Broad Bond Market
Given these various rate increases, how did fixed-income investments perform? Exhibit II shows that the broad bond market (as measured by the Barclays Capital Aggregate Bond Index) experienced some fluctuations within each rising rate period, but experienced positive cumulative returns over each full period.
Exhibit II: Broad Market Returns during Rising Rate Periods
Rising Rate Period 1
20
15
18.47
10
5
-2.92
0
-5
1994
0.01
1995 Cummulative Return
2/1/94 - 2/28/95
Rising Rate Period 2
11.63
-0.82
2.11
1999
2000 Cummulative
Return
6/1/99 - 5/31/00
Rising Rate Period 3
4.34
2.43
4.33
6.54
2004
2005
2006 Cummulative
Return
6/1/04 - 6/30/06
Source: Barclays Capital Live. Chart shows returns of Barclays Capital Aggregate Bond Index for years that include periods of the last three Fed rate increase cycles. Past performance does not guarantee future results. The chart is for illustrative purposes only and is not reflective of any Nuveen investment. Market indices do not include fees. You cannot invest directly in an index.
Why Duration is Only an Estimate Many investors may believe that the duration of an asset class is the absolute measure of what will happen during periods of rising rates. Classically defined, every one year of duration represents a 1% move in the price of the asset class for every 100 basis point move in rates. For example, a bond with duration of three years would decline 3% for each 1% increase in interest rates. While duration estimates the response of a fixed-income investment to changes in interest rates, there are three very important assumptions to remember:
1. Assumes parallel shift in the yield curve Duration assumes that all interest rates across the length of the yield curve increase by exactly the same amount. The assumption is that if the Federal Reserve raises the very short-term Federal Funds rate by 1%, the yield on the 30-year bond also increases by exactly 1%. In practice, this never happens. While short-term rates are anchored by the Federal Funds rate, intermediate- and long-term rates are driven by many other factors.
2. Assumes no change in credit spreads As we've established, any reduction in the credit spread of an asset class can help offset the impact of rising rates. Duration assumes that credit spreads remain constant, but in practice, credit spreads can shift dramatically over time. They often narrow as rates rise because economic expansion tends to lower risk premiums.
3. Estimates price impact only Duration only predicts the change in price of an investment as a result of interest rate changes. It cannot estimate the asset's total return. For example, a bond with a 3-year duration may decrease in price by 3% when rates rise, but it may also have a 5% yield. Over the next 12 months, that 3% price decline is offset by the 5% yield, resulting in a 2% total return.
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NUVEEN ASSET MANAGEMENT FIXED INCOME IN A RISING RATE ENVIRONMENT
MAY 2011
Impact Varies by Fixed Income Asset Class
The bond market consists of many different types of bonds as shown in Exhibit III. Some of these fixed-income asset classes are more or less sensitive to rising rates, depending on their characteristics.
Exhibit III: Asset Class Sensitivity to Rising Rates
Investment Type
Representative Index
Description
Effective Duration
Broad Bond Barclays Capital Market Aggregate Bond
Taxable Debt Treasuries Barclays Capital U.S. Treasury
Short Term Barclays Capital Corporates Credit 1-3 Year
Investment Barclays Capital Grade Credit U.S. Corporate
Investment Grade
U.S. investment grade bonds from three asset classes: government, corporate and securitized
Financed by the U.S. government, including bills, note and bonds
Investment grade debt of U.S. corporations with maturities of 1-3 years
Investment grade debt of U.S. corporations
5.01 yrs 5.21 yrs 1.83 yrs 6.40 yrs
Securitized Barclays Capital
Debt
U.S. Securitized
Senior Loans Credit Suisse Leveraged Loan
Securities backed by pools of assets, including residential mortgage-backed securities, commercial mortgage-backed securities and asset-backed securities
Floating interest rate, senior loans of corporations that typically reset their interest rates every 90 days
4.49 yrs 0.25 yrs
High Yield
Barclays Capital
Below investment grade rated
U.S. Corporate High debt of corporations
Yield
4.14 yrs
Tax-Exempt Municipal Barclays Capital
Debt Bonds
Municipal
Issued by states, municipalities, counties or their agencies
8.46 yrs
Hybrid Preferred Securities
BofAML Preferred Stock Fixed Rate
Special class of ownership in a 6.44 yrs company that often has both equity and debt characteristics
As of 3/31/11. Sources: Credit Suisse First Boston, BofA Merrill Lynch; Barclays Capital; Nuveen. 1 Yield to worst is the lowest potential yield that can be received on a bond without the issuer actually defaulting. 2 Difference in yield between index and equivalent duration Treasuries. 3 Tax equivalent yield at 35% tax rate. 4 Difference in yield between index and AAA-rated municipal bonds.
Yield-toWorst1 3.08% 2.01% 1.67% 4.07% 3.75%
5.33%
7.02%
5.94%3
6.08%
Average Yield
Spread2 81 basis
points
n/a
85 basis points 145 basis points
127 basis points
351 basis points
517 basis points
115 basis points4
319 basis points
Other Factors to Consider
Most commonly quoted bond index
Typically lower yielding since viewed as risk free
Less sensitive to rising rates because short term
Higher yields than U.S. government bonds Less volatility than lower rate issuers Duration can extend in rising rate environment as prepayments slow, making it more sensitive to rate changes
Low interest rate sensitivity due to adjustable rate Typically issued by lower quality companies and secured by a specific asset Higher yields than investment grade corporates due to increased credit risk Less sensitivity to rising rates due to higher yields Tax-exempt income Tend to be longer duration, but priced on municipal yield curve, which is less sensitive to rate changes Potential for additional yield due to subordinate position relative to debt holders
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