Michael Serio, CFA, Mt. Northwest
David Roda, CFA, Southeast
Cam Hinds, CFA, Great Lakes
Marc Doss, CFA, California
Sean McCarthy, CFA, Southwest
Kei Sasaki, CFA, Northeast   

In this Monthly Market Advisor:

  • Late in an economic cycle, the Federal Reserve ordinarily switches its focus from increasing employment to controlling inflation. To accomplish this, the central bank moves from a low-interest-rate stance to raising rates and tightening monetary policy.
  • With the Fed ramping up its tightening campaign, and every indication it may continue to hike for the foreseeable future, it's natural for investors to be apprehensive about investing in bonds.
  • If investors have not properly constructed their portfolios to reflect this rising-rate environment (bond prices move inversely to changes in interest rates), this can impact their portfolios. We believe it's important to understand the potential pitfalls of passive bond portfolios versus those that are actively managed.

Download the report (PDF)

Late in an economic cycle, such as the one U.S. investors currently are in, the Federal Reserve (Fed) ordinarily switches its focus from increasing employment to controlling inflation. To accomplish this, the central bank moves from an easy-money, low-interest-rate stance to one where it raises short-term interest rates and tightens monetary policy.

With the Fed having ramped up its tightening campaign and every indication it may continue to hike for the foreseeable future, it's natural for investors to be apprehensive about investing in bonds. We are taught bond prices move inversely to changes in interest rates—when interest rates rise, bond prices fall and vice versa. This fall can be meaningful if investors have not properly constructed their portfolios to reflect this environment. Since we have been in an era of decreasing rates for over 30 years, it is important to understand the potential pitfalls of passive bond portfolios versus those that are actively managed.

If you took a static, buy-and-hold portfolio and shocked it by shifting rates upward in a parallel fashion, the bonds in the portfolio would likely experience an instantaneous price drop—the magnitude depending on the length of the bonds' maturity as well as other factors. However, the entire yield curve rarely moves in a parallel fashion. Long, intermediate, and short rates all move independently for different reasons, such as:

  • How much the market expects rates will rise
  • Over what time period the rate increases occur
  • The outlook for inflation and GDP
  • The yield curve's shape prior to the hiking campaign
All these factors matter, some more than others.

Yes, Fed interest-rate hikes affect bonds—often most pronouncedly very-short term Treasury bonds. But how rate hikes affect longer-term bonds, with credit spreads and other risk factors, can be an entirely different story. Typically, when the market believes the Fed is going to tighten rates in succession, it views that as a preemptive strike against inflation, and we see the yield curve flatten. The table below shows previous rising-rate cycles and cumulative returns during those cycles.

Row Labels
12/15-Current
6/04-6/06
6/99-5/00
2/94-2/95
US Fund Intermediate-Term Bond
5.30
6.35
1.11
-1.57
US Fund Long-Term Bond
10.25
9.85
-0.25
-1.21
US Fund Multisector Bond
10.15
14.07
0.51
-3.75
US Fund Short-Term Bond
3.06
4.42
3.22
0.50
Grand Total
5.56
6.65
1.62
-1.11

Source: Morningstar Direct, 5/31/17. Past performance is no guarantee of future results.

It's important to remember that as the market anticipates the Fed raising rates, the yield curve typically begins to reflect that view by offering more yield for bonds directly affected by short-term rates. It is pricing in potential future rate hikes. It is only when rates rise faster and further than expected that bonds will underperform vs. holding cash. When we, as active managers, believe the curve is fairly valued and adequate rate hikes are priced in, it makes sense to us to own the curve by buying bonds, even some longer-duration bonds.

Active fixed income management can help mitigate some of the risk associated with fixed income exposure during periods of shifting interest rates. In our opinion, having the flexibility to position portfolios in light of market trends, select individual securities, avoid vulnerable parts of the yield curve, and seek out investments that tend to perform better in a rising-rate environment makes a strong case for active fixed income management. An investment professional can show an investor various simulated interest-rate scenarios to help the investor customize their risk/return relationship to help meet their investment needs.

Additionally, it's worth mentioning rising rates can add value to a bond portfolio in many ways. When initial bond purchases are made, assumptions about the reinvestment of coupon payments can be made to help calculate yield. If rates rise, coupon payments can be invested at higher rates to potentially improve the bond's total return over its life. For a perpetual allocation to fixed income, as maturities and coupon payments get reinvested at higher rates over time, the returns of the bond allocation can improve.

Lastly, we have heard many astute market analysts predict bonds would plummet in the face of rising interest rates each of the last seven or eight years only to be disproven over and over. In 2008, when the Fed moved its interest rate policy to zero, many investors opted out of bonds and into cash thinking interest rates had nowhere to go but up and we were in for a bear bond market. However, predicting the direction of interest rates and the velocity of those changes is extremely difficult, and no manager we know of has been able to capture those predictions consistently.

In our opinion, a conviction that the Fed will continue to raise interest rates is not a strong case for foregoing a fixed income allocation that can generate income and help provide a buffer from performance volatility in a well balanced portfolio due to low correlation to other markets. We believe investors are wise to continue to hold bonds in their portfolios, especially using an actively managed approach.