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Navigating Bonds in Today's Low-Rate Environment

Hunter Brackett, CFA®
Senior Manager | CAPTRUST Consulting Research Group

Nearly four years ago, the Federal Reserve cut its target interest rate to the lower bounds of its policy, where the rate remains today. While low interest rates are not a new phenomenon, two recent events have brought this issue back to the forefront of investors’ minds. First, the 10-Year U.S. Treasury — a useful proxy for interest rates — hit an alltime- low yield of 1.39% on July 24 amidst concerns about Europe’s debt crisis. Second, in September the Federal Reserve stated that it was willing to keep short-term interest rates at the present low levels through at least mid-2015 compared with the previous timeframe of 2014.

Under these circumstances, it may be an appropriate time for investors to reassess their portfolios and return expectations, particularly for fixed income assets. Going forward, we expect subdued returns in lower-yielding assets such as certificates of deposit, money market accounts, and fixed income securities for a number of reasons. The Fed actions discussed provide an incentive for investors to move away from lower-yielding assets and toward traditionally riskier areas such as equities. This is one of the reasons why the S&P 500 has rebounded so strongly off its March 2009 lows, recently approaching the all-time-high index level set in October 2007. In addition, many investors are concerned that interest rates can only go higher from today’s historically low levels. While the Fed will likely keep short-term rates anchored in the near term, it has less direct control over longer-term rates.
The biggest risk for bond returns is a sharp rise in interest rates, but several factors could prevent this scenario. Despite accommodative monetary policy from both the Fed and European Central Bank in recent months, economic fundamentals still appear weak and risks to global growth remain a concern.
In addition, demographic factors in the United States and a lack of viable substitutes for U.S. Treasurys as a safe haven asset could provide support even as rates rise. The forward curve, which represents market participants’ expectations for future interest rates, suggests a gradual rise in interest rates over the coming years. We also note that interest rates — which move in the opposite direction of bond prices — have staged short-lived rallies over the past few years, but in each instance have fallen as global growth concerns reemerged. For example, the yield on the 10-Year U.S. Treasury rose to 2.38% in March on stronger economic data, only to fall sharply and reach the previously cited all-time low in July.
We continue to encourage investors to diversify their allocations across subsectors of the bond market. Our research has shown that fi xed income returns can remain positive, even during periods of gradually rising rates, although subsectors may behave slightly differently. Given the prospect of higher long-term rates, investors may want to reduce interest rate risk while taking on a modest amount of credit risk. Credit-sensitive areas such as high-yield and emerging market debt may perform better than rate-sensitive subsectors such as Treasurys and investment-grade corporate bonds that tend to be more vulnerable to rising rates. 
While credit-sensitive subsectors tend to be more volatile, we believe that their fundamentals are supportive. Corporate balance sheets are much improved, as companies reduced costs during the recession and took advantage of low rates to refi nance their debt. Thus, default rates on high-yield debt are currently below their historical averages and are expected to rise at a modest pace going forward. It may also be useful to look outside of the U.S. market for bond exposure. Emerging market debt benefits from a stronger fiscal position relative to developed economies and favorable demographics, so exposure to this subsector may be appropriate depending on investor risk tolerance.
Another fixed income subsector that has received attention recently is mortgage-backed securities (MBS). The Fed recently announced another round of quantitative easing in which it will purchase $40 billion of MBS in the open market every month. Importantly, this program is open-ended and will continue until the labor market shows sustained improvement. Although this action is supportive of the MBS market, we note that some of the impact may have been priced into the market before the Fed announcement. While the housing market remains at a depressed level, fundamentals have started to improve, which could also aid the MBS market.
Following a multi-decade bull market in bonds and facing the prospect of rising interest rates, it may be tempting for investors to abandon this asset class. However, we continue to believe that bonds have an important role to play in client portfolios. They have historically been a less-volatile asset and provided a cushion during times of economic stress. Nevertheless, we expect subdued returns for fixed income going forward, so investors will need to be more selective with their asset allocation decisions. We also stress the value that active management can play in a more challenging fixed income backdrop. Having skilled portfolio managers who can profitably source the subsectors mentioned earlier can be additive.
We are constantly reviewing and assessing bond portfolios and money manager talent. If you have specific questions we can answer given these historic times, please do not hesitate to let us know.