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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 G42080-36.indd 1 3/16/2017 3:13:08 PM 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. G42080-36.indd 3 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. 3/16/2017 3:13:14 PM 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) Federated Investment Counseling G42080-36.indd 4 Federated is a registered trademark of Federated Investors, Inc. 2017 ©Federated Investors, Inc. 3/16/2017 3:13:14 PM