United States

Fixed Income in Perspective


Almost all investors have at least some fixed income securities as part of their strategic allocation. Some may invest in individual bonds; others may invest in fixed income mutual funds. Some investors hold more taxable bonds and others are more heavily weighted towards tax exempt bonds.

One of the main drivers behind investors holding fixed income securities is for diversification. Over time, the diversification that fixed income provides should lead to a portfolio with lower volatility vs. a portfolio of only equities. Fixed income investments can also be used to generate income, though clearly that has been more difficult in the low interest rate environment that we find ourselves in today.

The End of a 30 Year Bull Run for Bonds

Chart 1 displays the path that 10 year Treasury rates have taken since 1928. The high came in September 1981 when the 10 year Treasury hit 15.3 percent. The 30-year downward slope of 10-year Treasury rates from 1981 looks incredibly similar to the 30-ear run-up from the early 1950s to the early 1980s.

Chart 1

Chart 1

Source: Federal Reserve Board, as of April 30, 2011

As we know, there is an inverse relationship between bond prices and interest rates. As interest rates rise, bond prices fall and vice-versa. With this relationship in mind, there is understandably a concern that a rise in interest rates from current levels will have an adverse impact on fixed income investments. Here are some important things to think about in regards to your fixed income portfolio:

  1. Broad and global diversification is just as important with your fixed income investments as it is with your equity investments. Treasury, agency, municipal, corporate, foreign sovereign, mortgage-backed, and asset-backed bonds cover many of the key bond categories. Bonds can also range from short to long maturities. In addition, the economic drivers may be different depending upon the bond type and/or maturity; obviously impacting the yield. Having exposure to a variety of bond types and maturities provides needed diversification benefits and helps avoid risk concentrations.
  2. Timing the fixed income markets is just as challenging as timing the equity markets. Since the Federal Reserve lowered short term interest rates to near-zero levels in December 2008, we have heard that ‘rates have to rise at some point’ (a point highlighted by the fact that the Federal Funds rate is bound by zero on the low end). While we agree with that general statement, determining when rates will rise, how quickly they will rise, and by how much they will rise are topics of constant debate with no clear answers (i.e. there isn’t even agreement among the members of the Federal Open Market Committee!). Remember, the Federal Funds rate impacts the short end of the yield curve while other factors, like inflation expectations, play a large part in impacting the rest of the yield curve.
  3. As you can see from Chart 1, 10 year Treasury rates have stayed near the 4% level for an extended period in the past. Separately, while we have seen calls for rising rates, we have not seen anyone predict rates will rise to the highest levels seen in the early 1980s.
  4. Risk and return are always related in the long run. Whether it be investing in lower quality bonds and assuming more credit risk or extending maturities and taking on more interest rate risk, the higher return these strategies may provide comes at a price. It is critical to understand your time frame and risk appetite before consuming more risk.
  5. What exactly has a bear market in bonds looked like? As a simple measure, we looked at the worst annual returns for the S&P 500 (a common equity benchmark) as compared to the Barclays US Aggregate Bond Index (a common fixed income benchmark referred to as the BarCap Agg). Going back to 1976 (the inception of the BarCap Agg), the worst annual return for the BarCap Agg was -2.9% in 1994 while the S&P lost 37% in 2008. While we certainly cannot predict future performance, the BarCap Agg has historically provided solid capital preservation through the years, even during the periods of rising rates. Source: Morningstar
  6. In Chart 1 we can clearly see that there have been rising rate environments historically. How did the BarCap Agg perform during some of the other rising rate environments? Charts 2 and 3 will provide more detail.

Chart 2

Monthly Beginning

Month Ending Change in 10 Year Treasury Rates Cumulative Return of BarCap Agg Index
Jan-77 Mar-80 5.9 -2.8%
Apr-80 Jun-80 -3.0 18.8%
Jul-80 Sep-81 5.5 -9.0%
Jan-77 Sep-81 8.5 5.1%

Source: Federal Reserve, Morningstar

Chart 3

Monthly Beginning

Month Ending Change in 10 Year Treasury Rates Cumulative Return of BarCap Agg Index
Feb-83 Jun-84 3.1 6.4%
Feb-87 Mar-89 2.3 10.6%
Nov-93 Nov-941 2.6 -3.9%
Feb-96 Apr-97 1.2 3.9%
Nov-98 Jan-00 2.1 -0.3%
Nov-04 Jun-06 1.0 1.8%

Source: Federal Reserve, Morningstar

The charts above (charts 2 and 3) display various time periods of rising rates in the 10 year Treasury, the changes that occurred in 10 year Treasury rates, and the cumulative return of the Barclays US Aggregate Index over the corresponding time period. Here are some take-aways:

  • In Chart 2, the longer time period of January 1977 through September 1981 can be broken down into 3 sub-periods. Two of the sub-periods witnessed both increased rates and corresponding negative returns. However, the period from April 1980 through June 1980 saw both decreasing rates and strong, positive returns.
  • Also in Chart 2, despite the incredible rise in interest rates during the overall period from January 1977 through September 1981, the cumulative return of the index over the entire time period was positive. The need to be disciplined in sticking with a plan is clearly evident here.
  • Chart 3 highlights another six periods of rising interest rates. Only two of those periods corresponded with negative returns in the BarCap Agg.

The consistent thirty year decline in interest rates has been well documented. With the Fed Funds rate at record lows, investors are clearly anticipating higher rates at some point in the future. When rates rise, how much they rise, and how quickly they rise are questions receiving much attention with very little consensus as to their answers. We believe that taking a broad, global, and disciplined approach to your fixed income allocation is the best way to combat the uncertainty that exists in the fixed income markets today.

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