Download US Fixed Income: A Refresher on Rising Rates

MARKETVIEW
U.S.FixedIncome:ARefresheronRisingRates
April10,2017
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Here,werevisitthequestionofhowU.S.taxablebondsmayfareinthefaceof
risinginterestrates.
Inlastweek’sMarketView,welookedattheperformanceofthemunicipalbondmarketduring
periodsofU.S.FederalReserve(Fed)ratehikes.WeshowedthatnotallFed-tighteningcycles
arethesame.DuringcertainperiodswhentheFedhadraisedratesinaslowandgradualmanner,
throughawell-communicatedstrategy,long-termratesremainedrelativelystable,andlong-term
bondsperf ormedwell.
Asabondinvestor,itof tenismoreimportanttoconsidermovesinlonger-termratesratherthan
changesintheovernightratesdirectlycontrolledbytheFed,namelythef edf undsrate.So,when
investorsaskabouttheimpactof higherrates,ourf irstresponseisof ten:Whichratesareyou
talkingabout—f edf unds,U.S.Treasuryyields,orsomeothercategory?
Credit-sensitiveandequity-relatedsegmentsofthebondmarkethavehistoricallyhavegeneratedpositivereturnsduring
periodsofrisingT reasuryyields.
Inaddition,historyhasshownthattherecanbeawiderangeof returnsbyU.S.f ixed-income
assetclass,dependingonthemarketenvironment.So,anequallyimportantquestionsurf aces:
Whichtypesof bondsdoyouown?Thisweek,wewillreviewtheperf ormanceof variousbond
sectorsduringperiodof risinglong-termrates,asmeasuredbythe(representative)10-yearU.S.
Treasurynoteyield.
Thef inancialmediaof tenhavecharacterizedthepastthreedecadesasa“30-yearbullmarketf or
bonds.”ButasillustratedinChart1,whichtracksthemovementof theyieldonthe10-year
Treasurynote,thisbullmarkethasnotmovedinastraightline.Whileitgenerallyhasbeenan
environmentof declininginterestrates,therehavebeeneightseparateperiodswhenthe10-year
Treasuryyieldhasjumpedbymorethan100basispoints(bps)overashortperiod,mostrecently
inthesecondhalf of 2016.
Chart1.U.S.TreasuriesHavePostedNegativeReturnsWhenYieldsRoseMoreThan
100BasisPoints
Returnon10-yearU.S.Treasurysecuritiesduringeightperiodsofgreaterthan100basis-point
increaseinthe10-yearU.S.Treasuryyield,March31,1993–March31,2017
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Source:BloombergandMorningstar.
Note:10-yearTreasuryyieldasrepresentedbytheBloombergGeneric10-YearUnitedStatesGovernmentNote.10yearTreasuryperf ormanceasrepresentedbytheCitigroup10-YearTreasuryBondIndex.
*Riseof 100basispointsmusthaveoccurredwithina16-monthtimeperiod.
Pastperformanceisnoguaranteeoffutureresults.Perf ormanceduringotherperiodsmayhavebeendif f erent.
WhichBondsDoYouOwn?
Table1summarizesthereturnsof variousassetclassesduringtheseeightperiodsof rising
Treasuryyields.Eachof theseperiodsledtonegativereturnsf orthe10-yearTreasurynote,as
higheryieldstranslatedtolowerprices,withanaveragelossof 7.3%duringtheseeightperiods.
Table1.Historically,Lower-Duration,Credit-SensitiveBondsHavePerformedWellin
PeriodsofRisingLong-TermU.S.TreasuryYields
Indexreturnsduringperiodsofincreasesgreaterthan100basispointsinthe10-yearU.S.
Treasuryyield(month-endreturns)
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Source:Morningstar.
1Citigroup10-YearTreasuryBondIndex.2 BloombergBarclaysU.S.AggregateBondIndex.3Bof AMerrillLynchU.S.
CorporateBBB-Rated1-3YearIndex.4 Bof AMerrillLynchHighYieldMasterIIConstrainedIndex.5 CreditSuisse
LeveragedLoanIndex.6 BloombergBarclaysU.S.FloatingRateNoteIndex.7 Bof AMerrillLynchU.S.Convertible
Index.8 S&P500 ® Index.
Pastperformanceisnoguaranteeoffutureresults.Perf ormanceduringothertimeperiodsmayhavebeen
dif f erentornegative.
However,dif f erentassetclasseshadverydif f erentexperiencesintheseepisodes:long-duration
government-relatedsecuritiessuf f eredthemost,whilelower-durationandmorecredit-sensitive
bondshistoricallyperf ormedwell.TheBloombergBarclaysU.S.AggregateBondIndex,whichnow
hasanef f ectivedurationof 6.0yearsandislargelycomprisedof U.S.Treasuriesand
government-relatedsecurities,generatedlossesinsevenof theseeightperiods.
Movingdowntolower-durationandlower-ratedcredit,youwillseepositivereturnsinshort-term
corporatebonds,high-yieldcorporatebonds,andf loating-ratebankloansinalleightperiods.
Lookingatequity-relatedsecurities,stockswerepositiveineveryperiod,whileconvertiblebonds
werepositiveinallperiodsbutone.
WhyHasCreditDoneWellWhenRatesRise?
HigherTreasuryratesof tencoincidewithanimprovingeconomy,whichmayleadtoarisein
corporateearnings,bettercreditf undamentals,andincreasinginvestorappetitetotakeonrisk,
resultingindecliningcreditspreads.Thatspreadcompressioncanhelpof f setthemovehigherin
Treasuryrates.Thenif welookatspecif icassetclasses,wef ind:
Short-termcorporatebonds—Lowdurationleadstolimitedpricemovementsintheface
ofrisingrates.Additionalyieldspreadovergovernment-relatedsecuritiesprovideshigher
income,whilepotentialspreadtighteningcanpartiallyoffsethigherTreasuryrates.
High-yieldcorporatebonds—Althoughhigh-yieldbondsmayhaveanintermediatestated
duration,theyhistoricallyhavehadnegativecorrelationwithU.S.Treasurybonds.The
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effectofrisingTreasuryyieldshasoftenbeenoffsetbyspreadcompressionandhigh
couponincome,leadingtopositivereturnsinperiodsofrisingrates.
Floating-rateloans—Loansalsobenefitfromanimprovementincorporatecredit
associatedwithastrengtheningeconomy.Sinceloanshavecouponsthatadjustwithshorttermrates,typicallyevery90days,theycanbenefitfromariseinthebenchmarkLIBOR
(theLondoninterbankofferedrate,whichtypicallymovesinlinewiththefedfundsrate).In
addition,sinceloansdonothavethedurationexposureoftypicalfixed-ratebonds,prices
arenotaffectedbymovesinlong-termrates.
WhatDoesDurationTellUs?
Whenconsideringtheinterest-rateexposureof af ixed-incomeportf olio,manyinvestorslookat
theportf olio’sef f ectiveduration.Asanexample,f ollowingthesimplemathusedtoillustratethe
concept,aportf oliowithanef f ectivedurationof 5.0yearsisexpectedtodeclinebyapproximately
5%f ora100basis-pointmoveinrates.However,thereareaf ewpointstokeepinmind:
A“100basis-pointmoveinrates”referstoamoveintheyieldtomaturityonthatbondor
portfolio,nottheovernightfedfundsrate.
Thedeclineof“approximately5%”istheexpectedpricedecline,assumingthatthe100
basis-pointmoveinratesoccursimmediately,anddoesnotconsideranyincomeearned
overtime.
Durationisamathematicalcalculationbasedonthetimingofcashflowsonabond.It
doesnot,however,accountforthenegativecorrelationbetweenratemovesandspread
movesillustratedabove.Inotherwords,thiscalculationdoesnotadjustforthedifferent
behaviorofaU.S.Treasurybondandahigh-yieldcorporatebondthateachmayhavea
5.0-yeareffectiveduration.
Durationalonedoesnotgiveagoodindicationofinterestratesensitivity.
So,ratherthansimplyf ocusingonthestateddurationof aportf olio,itmaybebettertoexamine
theinterest-ratesensitivityof theportf olio.ThedatainTable1provideevidencethatef f ective
durationalonedoesnotgiveagoodindicationof trueinterest-ratesensitivityof credit-related
bondsectors,andsoisapoorindicatorof howsuchbondsmayperf ormduringrisingrateperiods.
Anotherwaytoviewtheserelationshipsisthroughcorrelationdata.Chart2showsthat‘BBB’rated
corporatebondsandhigh-yieldcorporatebonds,bothwithintermediateef f ectivedurations,
historicallyhavehadlowornegativecorrelationwithU.S.Treasuries.
Chart2.WhichBondCategoriesHavetheLowestCorrelationwithU.S.Treasuries?
CorrelationwithBloombergBarclaysU.S.GovernmentBondIndex,trailing10yearsasofMarch
30,2017
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Source:Morningstar.
1BloombergBarclaysU.S.GovernmentBondIndex.2 BloombergBarclaysU.S.AggregateBondIndex.3Bloomberg
BarclaysU.S.TreasuryU.S.TIPSIndex.4 BloombergBarclaysU.S.CorporateBaa-RatedIndex.5 Bof AMerrillLynch
U.S.CorporateBBB-Rated1-3YearIndex.6 BloombergBarclaysU.S.FloatingRateNoteIndex.7 BloombergBarclays
U.S.CorporateHighYieldIndex.8 Bof AMerrillLynchU.S.ConvertibleIndex.9 S&P500 ® Index.10 CreditSuisse
LeveragedLoanIndex.
Pastperformanceisnoguaranteeoffutureresults.Correlationisastatisticthatmeasuresthedegreeof
associationbetweentwovariables.
SummingUp
If historyisanyguide,investorswhoareexpectingarising-rateenvironmentmaywanttof avor
lower-durationassets.Butaninvestormaybebetterservedbydiggingalittledeeper—gaininga
greaterunderstandingof thetrueinterest-ratesensitivityof hisorherportf olio,whichcannotbe
measuredbydurationalone.
ThisMarketViewmaycontainassumptionsthatare“f orward-lookingstatements,”whicharebasedoncertain
assumptionsof f utureevents.Actualeventsaredif f iculttopredictandmaydif f erf romthoseassumed.Therecanbe
noassurancethatf orward-lookingstatementswillmaterializeorthatactualreturnsorresultswillnotbematerially
dif f erentf romthosedescribedhere.
ANoteaboutRisk:Thevalueof investmentsinf ixed-incomesecuritieswillchangeasinterestratesf luctuateandin
responsetomarketmovements.Generally,wheninterestratesrise,thepricesof debtsecuritiesf all,andwhen
interestratesf all,pricesgenerallyrise.Bondsmayalsobesubjecttoothertypesof risk,suchascall,credit,liquidity,
interest-rate,andgeneralmarketrisks.High-yieldsecurities,sometimescalledjunkbonds,carryincreasedrisksof
pricevolatility,illiquidity,andthepossibilityof def aultinthetimelypaymentof interestandprincipal.Moreover,the
specif iccollateralusedtosecurealoanmaydeclineinvalueorbecomeilliquid,whichwouldadverselyaf f ectthe
loan’svalue.Longer-termdebtsecuritiesareusuallymoresensitivetointerest-ratechanges;thelongerthematurity
of asecurity,thegreatertheef f ectachangeininterestratesislikelytohaveonitsprice.Lower-ratedbondsmaybe
subjecttogreaterriskthanhigher-ratedbonds.Noinvestingstrategycanovercomeallmarketvolatilityorguarantee
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f utureresults.Statementsconcerningf inancialmarkettrendsarebasedoncurrentmarketconditions,whichwill
f luctuate.
TreasuriesaredebtsecuritiesissuedbytheU.S.governmentandsecuredbyitsf ullf aithandcredit.Incomef rom
Treasurysecuritiesisexemptf romstateandlocaltaxes.AlthoughU.S.governmentsecuritiesareguaranteedasto
paymentsof interestandprincipal,theirmarketpricesarenotguaranteedandwillf luctuateinresponsetomarket
movements.
Abasispointisoneone-hundredthof apercentagepoint.
Durationisthechangeinthevalueof af ixed-incomesecuritythatwillresultf roma1%changeinmarketinterest
rates.Generally,thelargeraportf olio’sduration,thegreatertheinterest-rateriskorrewardf orunderlyingbond
prices.
Abondyieldistheamountof returnaninvestorwillrealizeonabond.Thoughseveraltypesof bondyieldscanbe
calculated,nominalyieldisthemostcommon.Thisiscalculatedbydividingtheamountof interestpaidbythef ace
value.
IntheUnitedStates,federalfunds(of tenref erredtoasfedfunds)areovernightborrowingsbetweenbanksand
otherentitiestomaintaintheirbankreservesattheU.S.FederalReserve.BankskeepreservesatFederalReserve
Bankstomeettheirreserverequirementsandtoclearf inancialtransactions.
TheLondoninterbankofferedrate(LIBOR)isaninterestrateatwhichbankscanborrowf unds,inmarketablesize,
f romotherbanksintheLondoninterbankmarket.TheLIBORisf ixedonadailybasisbytheBritishBankers'
Association.TheLIBORisderivedf romaf ilteredaverageof theworld'smostcreditworthybanks'interbankdeposit
ratesf orlargerloanswithmaturitiesbetweenovernightandonef ullyear.
TIPS(Treasuryinflation-protectedsecurities)areU.S.Treasurysecuritiesindexedtoinf lationinordertoprotect
investorsf romthenegativeef f ectsof inf lation.Theprincipalof aTIPisadjustedaccordingtotheCPI-U.Witharise
intheindex,orinf lation,theprincipalincreases.Withaf allintheindex,ordef lation,theprincipaldecreases.Though
therateisf ixedandpaidsemi-annually,interestpaymentsvarybecausetherateisappliedtotheadjustedprincipal.
Specif ically,theamountof eachinterestpaymentisdeterminedbymultiplyingtheadjustedprincipalbyone-half the
interestrate.Uponmaturity,TIPSpaytheoriginaloradjustedprincipalamount,whicheverisgreater.BecauseTIPS
areadjustedf orinf lation,achangeinrealinterestrates(butnotnominalinterestrates)willaf f ectthevalueof TIPS.
Whenrealinterestratesrise,thevalueof TIPSwilldecline,andwhenrealinterestratesf all,thevalueof TIPSwill
rise.
TheBloombergBarclaysCorporatesBaaIndexistheBaacomponentof theBloombergBarclaysU.S.Corporate
InvestmentGradeIndex.TheindexincludespubliclyissuedU.S.corporateandspecif iedf oreigndebenturesand
securednotesthatmeetthespecif iedmaturity,liquidity,andqualityrequirements.Toqualif y,bondsmustbeSECregistered.
TheBloombergBarclaysU.S.AggregateBondIndexrepresentssecuritiesthatareSEC-registered,taxable,and
dollardenominated.TheIndexcoverstheU.S.investment-gradef ixed-ratebondmarket,withindexcomponentsf or
governmentandcorporatesecurities,mortgagepass-throughsecurities,andasset-backedsecurities.Totalreturn
comprisespriceappreciation/depreciationandincomeasapercentageof theoriginalinvestment.
TheBloombergBarclaysU.S.CorporateHighYieldBondIndexisamarketvalue-weightedindexwhichcoversthe
U.S.non-investmentgradef ixed-ratedebtmarket.Theindexiscomposedof U.S.dollar-denominatedcorporatedebt
inIndustrial,Utility,andFinancesectorswithaminimum$150millionparamountoutstandingandamaturitygreater
than1year.Theindexincludesreinvestmentof income.
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TheBloombergBarclaysU.S.FloatingRateNoteIndexisdesignedtomeasuretheperf ormanceof U.S.dollardenominated,investmentgradef loatingratenotes.
TheBloombergBarclaysU.S.GovernmentBondIndexisamarketvalue-weightedindexcomposedof allpublicly
issued,nonconvertible,domesticdebtof theU.S.governmentoranyagencythereof ,quasi-f ederalcorporations,or
corporatedebtguaranteedbytheU.S.government.Flowerbondsandpass-throughissuesareexcluded.Totalreturn
consistsof priceappreciation/depreciationplusincomeasapercentageof theoriginalinvestment.Indexesare
rebalancedmonthlybymarketcapitalization.
TheBloombergBarclaysU.S.TIPSIndexisanunmanagedindexcomprisedof U.S.TreasuryInf lationProtected
Securitieswithatleast$1billioninoutstandingf acevalue.
TheBofAMerrillLynchU.S.HighYieldMasterIIConstrainedIndextrackstheperf ormanceof USdollar
denominatedbelowinvestmentgradecorporatedebtpubliclyissuedintheUSdomesticmarket.Qualif yingsecurities
musthaveabelowinvestmentgraderating(basedonanaverageof Moody’s,S&PandFitch),atleast18monthsto
f inalmaturityatthetimeof issuance,atleastoneyearremainingtermtof inalmaturityasof therebalancingdate,a
f ixedcouponscheduleandaminimumamountoutstandingof $100million.
TheBofAMerrillLynchU.S.CorporateBBB-Rated1-3YearIndexisanunmanagedindexcomprisedof U.S.dollar
denominatedinvestmentgradecorporatedebtsecuritiespubliclyissuedintheU.S.domesticmarketwithbetweenone
andthreeyearremainingtof inalmaturity.
TheBofAMerrillLynchU.S.ConvertibleIndextrackstheperf ormanceof publiclyissuedU.S.dollar-denominated
convertiblesecuritiesof U.S.companies.Qualif yingsecuritiesmusthaveatleast$50millionf aceamountoutstanding
andatleastonemonthremainingtothef inalconversiondate.
SourceMerrillLynch,Pierce,Fenner&SmithIncorporated(“Bof AML”),usedwithpermission.Bof AMLPERMITSUSE
OFTHEBof AMLINDICESANDRELATEDDATAONAN"ASIS"BASIS,MAKESNOWARRANTIESREGARDINGSAME,
DOESNOTGUARANTEETHESUITABILITY,QUALITY,ACCURACY,TIMELINESS,AND/ORCOMPLETENESSOF
THEBof AMLINDICESORANYDATAINCLUDEDIN,RELATEDTO,ORDERIVEDTHEREFROM,ASSUMESNO
LIABILITYINCONNECTIONWITHTHEUSEOFTHEFOREGOING,ANDDOESNOTSPONSOR,ENDORSE,OR
RECOMMENDLORD,ABBETT&CO.LLC.,ORANYOFITSPRODUCTSORSERVICES.
TheCitigroup10YearTreasuryBondIndexisabroadmeasureof theperf ormanceof themedium-termU.S.
Treasurysecurities.
TheCreditSuisseLeveragedLoanIndexisdesignedtomirrortheinvestableuniverseof theU.S.dollardenominatedleveragedloanmarket.
TheS&P500 ® Indexiswidelyregardedasthestandardf ormeasuringlargecapU.S.stockmarketperf ormanceand
includesarepresentativesampleof leadingcompaniesinleadingindustries.
ANoteaboutIndexes:Indexesareunmanaged,donotref lectthedeductionof f eesorexpenses,andarenot
availablef ordirectinvestment.Indexesdepictedhereinaref orillustrativepurposesonlyanddonotrepresentany
specif icportf oliosmanagedbyLordAbbettoranyparticularinvestments.Otherindexesmaynothaveperf ormedin
thesamemannerundersimilarconditions.
Thecreditqualityof thesecuritiesinaportf olioisassignedbyanationallyrecognizedstatisticalratingorganization
(NRSRO),suchasStandard&Poor’s,Moody’s,orFitch,asanindicationof anissuer’screditworthiness.Ratings
rangef rom‘AAA’(highest)to‘D’(lowest).Bondsrated‘BBB’oraboveareconsideredinvestmentgrade.Creditratings
‘BB’andbelowarelower-ratedsecurities(junkbonds).High-yielding,non-investment-gradebonds(junkbonds)involve
higherrisksthaninvestmentgradebonds.Adverseconditionsmayaf f ecttheissuer’sabilitytopayinterestand
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principalonthesesecurities.
TheopinionsinMarketViewareasof thedateof publication,aresubjecttochangebasedonsubsequent
developments,andmaynotref lecttheviewsof thef irmasawhole.Thematerialisnotintendedtoberelieduponas
af orecast,research,orinvestmentadvice,isnotarecommendationorof f ertobuyorsellanysecuritiesortoadopt
anyinvestmentstrategy,andisnotintendedtopredictordepicttheperf ormanceof anyinvestment.Readersshould
notassumethatinvestmentsincompanies,securities,sectors,and/ormarketsdescribedwereorwillbeprof itable.
Investinginvolvesrisk,includingpossiblelossof principal.Thisdocumentispreparedbasedontheinf ormationLord
Abbettdeemsreliable;however,LordAbbettdoesnotwarranttheaccuracyandcompletenessof theinf ormation.
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