Download OnPoint—Strategies to benefit from rising rates

ederated
• Not all fixed-income asset
classes respond the same to
a rising-rate environment.
Investors can still diversify their
portfolios with fixed-income
instruments, but it is crucial to
know which ones.
• Among true fixed-income
instruments, asset classes that
tend to do best are: highyield bonds, investment-grade
bonds, emerging-markets
debt, floating-rate securities
and short duration bonds.
• Just as a diverse portfolio
of equity and bonds is
recommended for individual
investors, it may be best to
diminish risk during Fed
tightening by spreading
exposure over several of these
bond categories.
“Are we there yet?” “Are we there yet?” That timeless cry of frustration from kids on
road trips could easily have been uttered by investors tired of wondering if interest
rates were ever going to rise. For much of the decade, Federal Reserve policymakers
have been saying, “Not yet.’’ But by most accounts—and by the Fed itself—2017 is
finally the year we may get a true tightening cycle. So what are the best investment
vehicles to navigate through a rising-rate environment?
A rising-rate environment historically has tended to favor equities over bonds, particularly
early in a tightening cycle. Higher rates are viewed as affirmation of an improving
economy that can produce more revenue and profit growth for companies, and earnings
are the primary driver of stock prices. We already are experiencing this phenomenon,
with the major U.S. equity indexes hitting a series of new highs in the months since the
Fed in December 2016 initiated its second rate increase in as many years and signaled
potentially three more in 2017.
Equities have increased with rising rates
520
495
S&P 500
• Rising-rate periods—
particularly early in the
cycle—have tended to be
favorable for equities.
Strategies to benefit from rising rates
S&P 500
• The Federal Reserve’s
modest rate hikes of the
last two years—widely spaced
and oft delayed—are better
understood as normalization
rather than tightening.
We now appear to be in
a bona fide tightening cycle
driven by an improving
U.S. economy.
470
445
420
2/94
3/95
Federal Funds Rate Rose 2.75%
1550
1480
1410
1340
1270
1200
6/99
6/00
Federal Funds Rate Rose 1.50%
1350
S&P 500
Executive Summary
A Series of Industry
and Investment Insights
1250
1150
1050
6/04
7/06
Federal Funds Rate Rose 4.00%
Source: Bloomberg. Past performance is no guarantee of future results. These charts are for illustrative purposes only
and not representative of performance for any particular investment. These charts are for select time periods. Results
over different periods would have varied. Indexes are unmanaged and cannot be invested in directly.
To be sure, some of the equity market’s run in late 2016-early 2017 has a lot to do with
November’s election. The Republican sweep has ushered in a new mindset among
investors, with hope replacing worry as a prevailing mood if various sentiment surveys
are to be believed. This is being fed by expectations for a rash of new business-friendly
policies, including corporate tax reform, regulatory relief and ramped-up defense and
infrastructure spending, under the new regime.
NOT FDIC INSURED • MAY LOSE VALUE • NO BANK GUARANTEE
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But at its core, the post-election run-up in equities has a lot
to do with improving fundamentals that typically drive the
market. Consumer and business confidence is soaring, GDP
growth forecasts are being revised up and U.S. corporate
profits—the foundation of stock prices—have now risen
two consecutive quarters through 2016 and are projected
to continue this uptrend. Equity investors desiring to participate in this reaccelerating growth may wish to keep an eye
on cyclical, energy and financial stocks that historically have
performed better when the economy is performing better.
As the world’s largest economy, an improving U.S. also
tends to carry over to much of the rest of the world,
making international stocks worthy of consideration, too.
For equity investors desiring income and less risk during
inevitable market sell-offs, dividend-paying stocks may be an
option. Companies with a history of paying and increasing
dividends tend to be mature and well established, and pay
dividends regardless of the rate or market environment.
Their share price may suffer relative to growth stocks
during strong risk-on periods such as the final months
of 2016 and early 2017. But over time, this can prove
beneficial as dividends are reinvested at a lower share price,
meaning the long-term investor is paying less for the same
dividend cash flow.
Dividend-paying stocks have delivered in the recent
rising-rate period
Cumulative Total Return (%)
11/30/15 - 1/31/17
Total Return 18.69
Income
4.32
Dow Jones Select
Dividend Index
Price Appreciation 14.37
Total Return -0.36
10-Year Treasury
Index
Income 1.78
Price Depreciation -2.14
-5
0
5
10
15
20
Sources: Morningstar, Inc. and Bloomberg. BofA Merrill Lynch U.S. Treasury
Current 10-Year Index was used. The 10-year Treasury yield at 11/30/15 was
2.21% and 2.45% at 1/31/17 with an increase of 0.24% for the time period.
Past performance is no guarantee of future results. This chart is for illustrative
purposes only and not representative of performance for any particular
investment. Investments cannot be made directly in an index.
This example does not show the tax consequences of each type of investment.
Rising rates have not adversly affected the returns of all bond and bond-proxy classes
U.S. Treasury
10-Yr. Yield
Increase (%)
Bloomberg
Barclays
U.S. Aggregate
Bond Index (%)
Credit Suisse
Leveraged
Loan
Index (%)
Bloomberg
Barclays
Corporate
High Yield
Bond Index (%)
Dow Jones
Select
Dividend
Index (%)
J.P. Morgan
EMBI Global
Index (%)
Rising-Rate Environments
Beginning
Date
Ending
Date
9/30/93
11/30/94
2.53
-3.03
11.34
1.69
-0.54
-
12/31/95
8/31/96
1.37
-1.11
5.42
5.06
8.54
19.46
9/30/98
1/31/00
2.24
-0.61
4.92
3.07
2.09
26.15
10/31/01
3/31/02
1.17
-1.91
3.99
4.96
22.27
5.68
5/31/03
8/31/03
1.10
-2.91
2.32
2.91
4.91
-1.20
8/31/05
6/30/06
1.12
-1.16
5.11
2.81
4.25
2.89
12/31/08
12/31/09
1.63
5.93
44.87
58.21
11.13
28.18
8/31/10
3/31/11
1.00
-0.77
7.40
10.46
21.78
0.81
4/30/13
12/31/13
1.36
-2.89
2.92
2.57
11.82
-7.01
7/29/16
12/31/16
1.00
-3.14
3.96
4.57
3.46
-2.16
Source: Morningstar, Inc.
The returns shown are total returns.
Past performance is no guarantee of future results. This chart is for illustrative purposes only and not representative of performance for any particular investment.
Indexes are unmanaged and cannot be invested in directly.
Fixed-income options
Investors needing income know that interest rates don’t
treat all bond classes the same. True, the inverted relationship between bond prices and yields means most bonds are
negatively impacted when rates rise (See box: Why are rising
rates bad for bonds?) But that impact tends to be far greater
G42080-36.indd 2
on government bonds whose returns are closely tied to the
level of interest rates. The performance of credit-oriented
high-yield, investment-grade corporate and emerging-market
bonds can be driven as much if not more by corporate and
economic performance than by interest rates alone.
3/16/2017 3:13:13 PM
Why are rising rates bad for bonds?
Say you invested $1,000 in a 10-year Treasury bond
yielding 2% and wanted to sell it three years later after
rising-interest rates have pushed new issuance to 4%.
An investor is unlikely to want your lower-yielding bond
over a new bond; you’d have to sell it for less than you
bought it. This is why rising rates can hurt bonds. But it’s
important to remember that bond mutual funds don’t just
buy and hold one bond; these portfolios are constantly
turning over. So as yields rise (and bond prices fall), new
bonds are being purchased at cheaper prices, lessening
the potential impact of higher yields on older portions of
the portfolio. It is a sort of built-in dollar-cost-averaging
mechanism, if you will.
Once considered a more risky niche, the emerging-markets
(EM) debt asset class has grown in size and improved in
quality. Even though growth in many markets has slowed,
expectations for future growth remain above that of developed countries. Strengthening fiscal and monetary oversight
among emerging economies combined with youthful
demographics, growing urbanization and a burgeoning
middle class all point to the potential for a positive,
long-term growth trend. In addition, economic and
political stability in some emerging economies is helping
the corporate sector to flourish. While Fed tightening and
the dollar’s strength could represent headwinds, many EM
countries stand to benefit if the U.S. economy accelerates.
Emerging markets have generated attractive returns
even as rates have risen
Corporate and emerging-market bonds
High-yield bond performance in times of rate growth
Time Period
Length
of Time
Yield
Increase
Total Return
of High-Yield
Bonds
9/30/98-1/31/00
16 Months
2.24%
3.07%
12/31/08-12/31/09
12 Months
1.63%
58.21%
4/30/13-12/31/13
8 Months
1.36%
2.57%
12/1/15-1/31/17
14 Months
0.24%
13.43%
Source: Morningstar, Inc.
High-yield bonds represented by Bloomberg Barclays U.S. Corporate
High Yield U.S. Dollar Index.
Past performance is no guarantee of future results. This chart is for illustrative
purposes only and not representative of performance for any particular
investment. Investments cannot be made directly in an index.
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13,500
Return 27.32%
$12,732
13,000
Growth of $10,000
Because they are by definition tied to a company’s financial
performance, high-yield and investment-grade corporate
bonds tend to be less sensitive to rate changes than other
fixed-income instruments. This is especially true when rates
are rising because the economy is improving, as is the case
currently. As mentioned earlier, improved economic growth
is supportive of corporate profits and balance sheets. That
said, the spread—or difference—between rates on corporate
bonds and comparable maturity Treasury securities
narrowed significantly in 2016, reducing potential returns
even as corporate bonds continued to offer attractive
coupons relative to lower-yielding Treasuries.
12,500
12,000
11,500
11,000
10,500
— J.P. Morgan EMBI Global
10,000
9,500
8/31/13
9/30/14
9/30/15
9/30/16
Source: Morningstar, Inc.
Growth of hypothetical $10,000 investment from 8/31/13 to 9/30/16. This chart
is for illustrative purposes only and not representative for any particular
investment. This chart is for a selected time period. Results over different
periods would have varied. Investments cannot be made directly in an index.
Other fixed-income options include floating-rate
investment vehicles—so-called because they invest
primarily in a mix of lower-duration, low-correlation
fixed-income instruments whose interest rates “float,’’ or
rise and fall, with changes in market rates. These securities
are pegged to and are reset (typically every 30 to 90 days)
at a spread over prevailing short-term rates, such as
the London interbank offered rate (Libor). As a result,
floating-rate securities generally exhibit less rate sensitivity
than fixed-rate bonds. Floating-rate debt may include bank
loans, corporate, municipal and asset-backed securities, and
adjustable-rate mortgages.
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A balanced approach may be best
Because rising-rate periods differ according to the economic
and market dynamics in place at the time, a mix of equity
and fixed-income products may be preferable for the longterm investor. This diversification between equity and bond
sources may help lessen the impact of a down period in any
particular asset class while also providing the opportunity to
participate in a growing economy that typically accompanies
the early stages of a rising-rate cycle such as we are in now.
Duration is also important
■ 2-Year Treasury ■ 10-Year Treasury
2
1-Year Total Return (%)
Think of duration as the number and length of your steps
as you hike up a mountain. The more and shorter the steps
are, the easier it is to ascend the steep slopes. In a period of
rising rates, short-duration bonds follow the same principal. By
maturing quickly—durations can range from three months
to three years—short-duration bonds can lessen the damage
from higher rates by allowing investors to reinvest maturing
money into higher-yielding securities.
0.72%
0.23%
0
-2
-0.25%
-1.58%
-4
-6
-5.41%
-8
-10
-12
-9.15%
+50 bps
+100 bps
+150 bps
Change in Interest Rates (bp)
This hypothetical chart illustrates 2- and 10-year Treasury bonds 1-year
total return if interest rates were to change by 50, 100 and 150 basis
points based on the current yield as of 2/28/17. The current yield for the
2-year Treasury is 1.21% and for the 10-year Treasury is 2.36%.
Source: Bloomberg as of 2/28/17.
Past performance is no guarantee of future results. For illustrative purposes
only. Actual interest rate changes will vary. Returns presented are not
representative of the performance of any particular investment.
Views are as of March 8, 2017 and are subject to change based on market conditions and other factors. This should not be construed as a recommendation for any
specific security or sector.
Bloomberg Barclays U.S. Aggregate Bond Index is an unmanaged index composed of securities from the Barclays Government/Corporate Bond Index,
Mortgage-Backed Securities Index and the Asset-Backed Securities Index. Total return comprises price appreciation/depreciation and income as a percentage
of the original investment. Indices are rebalanced monthly by market capitalization.
Bloomberg Barclays U.S. Corporate High Yield Bond Index measures the USD-denominated, high yield, fixed-rate corporate bond market. Securities are classified
as high yield if the middle rating of Moody’s, Fitch and S&P is Ba1/BB+/BB+ or below. Bonds from issuers with an emerging markets country of risk, based on the
indices’ EM country definition, are excluded. The US Corporate High Yield Index is a component of the U.S. Universal and Global High Yield Indices. The index was
created in 1986, with history backfilled to July 1, 1983.
Credit Suisse Leveraged Loan Index is designed to mirror the investable universe of the U.S. dollar denominated leveraged loan market. Average values are
computed over the Index for coupon, current yield, initial spread and price. The average coupon, current yield and initial spread are weighted by market value
(amount outstanding multiplied by the price) at the end of the measurement period for each loan currently paying interest in the Index. Total return is computed
for each loan, which is the percent change in the value of each loan during the measurement period. Total return is the sum of three components: principal,
interest and reinvestment return.
Dow Jones Select Dividend Index universe is defined as all dividend-paying companies in the Dow Jones U.S. Total Market Index that have a non-negative
historical 5-year dividend-per-share growth rate, a 5-year average dividend earnings-per-share ratio of less than or equal to 60%, and 3-month average daily
trading volume of 200,000 shares. Current index components are included in the universe regardless of their dividend payout ratio. The Dow Jones U.S. Total Market
Index is a rule-governed, broad-market benchmark that represents approximately 95% of the U.S. market capitalization.
J.P. Morgan Emerging Markets Bond Index Global tracks total returns for traded external debt instruments in the emerging markets.
S&P 500 Index is an unmanaged capitalization weighted index of 500 stocks designated to measure performance of the broad domestic economy through changes
in the aggregate market value of 500 stocks representing all major industries.
Variable and floating rate loans and securities generally are less sensitive to interest rate changes but may decline in value if their interest rates do not rise as much
or as quickly as interest rates in general. Conversely, variable and floating rate loans and securities generally will not increase in value as much as fixed rate debt
instruments if interest rates decline.
Dollar cost averaging does not assure a profit or protect against loss in declining markets.
Duration is a measure of a security’s price sensitivity to changes in interest rates. Securities with longer durations are more sensitive to changes in interest rates
than securities of shorter durations.
Bond prices are sensitive to changes in interest rates, and a rise in interest rates can cause a decline in their prices.
While stocks offer the potential for greater returns than bonds, they tend to be more volatile. There are no guarantees that dividend paying stocks will continue to
pay dividends. In addition, dividend paying stocks may not experience the same capital appreciation potential as non-dividend paying stocks.
High-yield, lower-rated securities generally entail greater market, credit/default and liquidity risks, and may be more volatile than investment grade-securities.
International investing involves special risks including currency risk, increased volatility, political risks, and differences in auditing and other financial standards.
Prices of emerging markets securities can be significantly more volatile than the prices of securities in developed countries and currency risk and political risks are
accentuated in emerging markets.
Diversification does not assure a profit nor protect against loss.
G42080-36 (3/17)
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