Mark Paccione, CFA, CFP®
Director | CAPTRUST Wealth Practice Leader
Today, three things are certain: death, taxes, and rising interest rates. While this is said somewhat tongue in cheek, interest rates’ future path is presently a key topic in meetings with investment professionals and clients alike. The topic is especially pertinent for those investors reliant on fixed income and other yield-generating investments for income. Understandably, their common fear is that — with interest rates near all-time lows — rates will rise in the future causing bond investments to suffer, resulting in losses.
When investors refer to historically low interest rates, they are referring first and foremost to U.S. Treasury yields. As Figure One demonstrates, interest rates are near historically low levels as measured by the 10-year U.S. Treasury. The 10-year yield reached a low of 1.39% last July before rebounding to its current level of just under 2%, as equity markets rallied over that same time period. CAPTRUST believes the trend will continue, and interest rates will move higher over time; however, some perspective is in order.
First, we expect interest rates to gradually move higher going forward. In this scenario, yield may offset the decline in underlying bond prices, meaning that fixed income investments can still deliver positive total returns. CAPTRUST research has shown that fixed income total returns were, in fact, positive over past gradual rising rate environments. Second, at the security level, the only way to lose money on a bond purchased at issue and held to maturity is via default. This fact is often forgotten when discussing fixed income in the current environment. If, for example, a client buys a bond at issue and interest rates spike right after the bond purchase, the bond’s price may immediately drop; however, if the client holds the bond to maturity and does not default, the investor will continue to collect yield for the bond’s life and earn a positive total return, regardless of interest rate moves after the purchase. While this example neglects any negative impact from trading or inflation and ignores the opportunity cost of not investing in a bond at a higher interest rate, it does highlight fixed income investments’ lower risk of permanent capital loss.
More relevant to investors seeking portfolio income are non-Treasury fixed income instruments such as municipal securities, investment-grade corporate bonds, high-yield fixed income, and mortgage bonds. Municipal bonds remain attractive today with 10-year, AAA-rated general obligation bonds hovering around 2%. Historically, municipal bonds have traded at a premium to Treasurys due to their tax treatment; however, since 2008, they have traded at a discount and continue to do so, albeit at a smaller discount than several years ago. Further, recent increases in federal tax rates, combined with tax increases in some states, make the favorable tax treatment municipal bonds receive more valuable today than several months ago.
Corporate bonds, both investment grade and high yield, trade at spreads over Treasurys as investors demand more compensation for bearing higher default risk. While spreads have come down over time, many remain above pre-2008 levels as indicated by the BBB corporate bond chart (Figure Two) above. If the economy continues to grow as expected, corporate balance sheets should continue to improve and spreads should contract further, which would help offset the expected concurrent rise in interest rates.
However, a word of caution is in order. Investors should pay attention to duration — a measure of interest rate sensitivity. Duration reveals the sensitivity of the value of a fixed income investment, like a bond or bond portfolio, to a change in interest rates. The higher the duration, the greater the sensitivity to rate changes, and vice versa. For example, if a bond has a duration of five years, a 1% increase in rates would cause the value of the bond to decline by approximately 5%. Conversely, a 1% decline in interest rates would cause the bond’s value to go up by about 5%. With interest rates grinding higher, we have taken steps to reduce duration in clients’ portfolios in an effort to decrease interest rate sensitivity. As a reference, the Barclays Aggregate Bond Index — a broad measure of the fixed income market — has a duration of 5.30 years. For CAPTRUST discretionary relationships, we are presently targeting portfolio duration below four years.
Another area of the fixed income market that has done well is the non-agency mortgage market, which consists of mortgages not insured by the federal government. After the housing bubble burst in 2008, non-agency mortgage bonds sold off to trade at discounts. As the housing market and economy have improved, the price of mortgage bonds has also improved, although many still trade at a discount. Should the economy and housing market continue their rebounds, non-agency mortgage bonds should do well, although not as well as the past few years. One added benefit of non-agency mortgages is the fact that most non-agency mortgages trade at a discount, so the risk of an individual bond being called away is low.
Going forward, floating rate bonds will be an interesting fixed income market subset to watch. Floating rate bonds are comprised of bundles of bank loans made to corporations usually with below-investment-grade credit ratings. These loans typically have seniority in a firm’s capital structure and the highest claims to a borrower’s assets in the event of default. Unlike traditional bonds with a fixed coupon rate, floating rate bonds’ interest payments are based on an underlying floating reference rate such as the London Interbank Offered Rate (LIBOR), the interest rate at which banks can borrow funds from other banks. As prevailing market interest rates fluctuate, floating rate bonds’ coupon payments change as well. Because the coupon payment fluctuates, floating rate bond prices exhibit low sensitivity to interest rate changes, making them attractive in a rising-rate environment.
Non-fixed income investments, including dividend-paying stocks, Master Limited Partnerships (MLPs), and Real Estate Investment Trusts (REITs) continue to perform well, trading more in line with equity markets than fixed income markets. For example, the Dow Jones Select Dividend Index — an index of dividend-paying stocks — was up 11.78% in the first quarter of 2013, compared to 10.61% for the S&P 500. Given the index’s exposure to utilities, it is surprising to see such outperformance over the S&P 500, which includes traditionally higher-beta sectors such as technology. The Alerian MLP Index returned an impressive 19.74% in the first quarter. With low interest-rate sensitivity and the possibility of capital appreciation, non-fixed income yield investments may be of interest to investors seeking yield, while mitigating overall interest rate sensitivity.
Investors are flocking to investments in these categories, perhaps indicating that money is moving from traditional fixed income into non-fixed income yield investments. While this may make long-term sense given yields near historical lows and equity markets near all-time highs, investors should exercise caution as many of these instruments trade like traditional equities in declining markets and with significantly more volatility than core fixed income.
While concerns about rising interest rates are not entirely unfounded, we expect interest rates to move higher only gradually. In this kind of environment, fixed income investments can still deliver positive total returns. Further, by creating a portfolio with a variety of income-generating securities that respond to varying factors and market conditions, investors can enjoy a portfolio that generates income, while minimizing exposure to risk.