A Tough Stretch for High Quality Bonds

It’s been a difficult stretch for fixed-income investors since yields bottomed in the summer of 2016.

As shown on the following chart published on the LPL Financial Research Blog, the 2-year cumulative total return for the broad high-quality bond market (as represented by the Bloomberg Barclays Aggregate Index) is negative for the first time in nearly 40 years.

As the business cycle has normalized, the economy is relying less on monetary policy and is transitioning to more typical drivers like corporate fundamentals and fiscal stimulus. As a result, interest rates have risen to more normalized levels. Although this is ultimately a positive sign that reflects a strengthening economy, it has made for a challenging two years in high-quality fixed income.

“Economic growth, deficit spending, rising inflationary pressures, and expectations for future rate hikes have lifted rates over the past two years,” according to LPL Chief Investment Strategist John Lynch. “Although interest rates may likely move higher in the year ahead, we believe the pace of the last two years will not be replicated.”

Investors have felt the pain of higher interest rates in the form of lower bond prices. However, investors may stand to gain over time as they generally receive more interest than they pay. Two years ago, yields across the globe were extremely depressed, with the 10-year Treasury yield reaching its all-time low of 1.36% on July 8, 2016.

The 10-year yield has more than doubled since then. Investors may take solace since it is very possible that the next one or two years may not be as challenging for fixed income investors as the past two have been. Long-term interest rates currently reflect meaningfully higher levels of growth and inflation than they did two years ago.

LPL Financial Research has already seen indications that the pace of interest rate increases has slowed, which was reflected in the quarter-over-quarter performance of the Barclays Aggregate. Though the second quarter return was negative, it was much less so than the first quarter, pointing to a rate environment that reflects the economic realities of a strengthening U.S. economy.

Although investors may be questioning the worth of high-quality fixed income in their diversified portfolios, I think maintaining exposure to this market sector may likely help manage equity market risk in the face of higher volatility. As the business cycle ages, I think high-quality fixed income may become more important for suitable investors seeking income.

Important Disclosures

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual security. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. The economic forecasts set forth in this material may not develop as predicted.

Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates risk and bonds are subject to availability and change in price.

There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.

All indexes are unmanaged and cannot be invested into directly. Unmanaged index returns do not reflect fees, expenses, or sales charges. Index performance is not indicative of the performance of any investment. All performance referenced is historical and is no guarantee of future results.

Investing involves risks including possible loss of principal. No investment strategy or risk management technique can guarantee return or eliminate risk in all market environments.

This research material has been prepared by LPL Financial LLC.

To the extent you are receiving investment advice from a separately registered independent investment advisor, please note that LPL Financial LLC is not an affiliate of and makes no representation with respect to such entity.

The investment products sold through LPL Financial are not insured deposits and are not FDIC/NCUA insured. These products are not Bank/Credit Union obligations and are not endorsed, recommended or guaranteed by any Bank/Credit Union or any government agency. The value of the investment may fluctuate, the return on the investment is not guaranteed, and loss of principal is possible.

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Rates on the Rise: Strategies for Fixed-Income Investors

A long period of low yields has been challenging for many fixed-income investors, but owning bond investments in a rising interest-rate environment could become even trickier. When interest rates go up, the prices of existing bonds typically fall. Consequently, the Federal Reserve’s rate-setting decisions could affect the entire fixed-income market.

RisinginterestratesiStock_000078549611_MediumStill, bonds are a mainstay for conservative investors who prioritize the preservation of principal over returns, and for retirees in need of a predictable income stream. Although diversification does not guarantee a profit or protect against investment loss, owning a diversified mix of bond types and maturities is one way to manage interest-rate and credit risk in your portfolio.

Consider duration
Overall, bonds with shorter maturities are less sensitive to interest-rate fluctuations than long-term bonds. A bond’s maturity is the length of time by which the principal and interest are scheduled to be repaid. A bond’s duration is a more specific measure of interest-rate sensitivity that takes cash flow (interest payments) into account.

For example, a five-year Treasury bond has a duration of less than five years, reflecting income payments that are received prior to maturity. A five-year corporate bond with a higher yield will have an even shorter duration, making it slightly less sensitive to interest-rate fluctuations. If interest rates increase 1%, a bond’s value is generally expected to drop by approximately the bond’s duration. Thus, a bond with a five-year duration could lose roughly 5% in value. (U.S. Treasury securities are guaranteed by the federal government as to the timely payment of principal and interest.)

Build a ladder
Bond laddering is a buy-and-hold strategy that could also help cushion the potential effects of rising rates. This process puts your money to work systematically, without trying to predict rate changes and time the market.

file0001084609609Buying individual bonds provides some certainty, because investors know how much they will earn if they hold a bond until maturity, unless the issuer defaults. A ladder is a portfolio of bonds with maturities that are spaced out at regular intervals over a certain number of years. When short-term bonds from the low rungs of the ladder mature, the funds are reinvested at the top end of the ladder.

As interest rates rise, investors may be able to increase their cash flow by capturing higher yields. A ladder may also help insulate bond portfolios from volatility, because higher yields on new bonds may help offset any paper losses on existing holdings.

Bond ladders may vary in size and structure, and could include different types of bonds depending on an investor’s time horizon, risk tolerance, and goals. Individual bonds are typically sold in minimum denominations of $1,000 to $5,000, so creating a bond ladder with a sufficient level of diversification might require a sizable investment.

Rise with rates
Adding a floating-rate component to a bond portfolio may also provide some protection against interest-rate risk. These investments (long offered by U.S. corporations) have interest payments that typically adjust based on prevailing short-term rates.

The U.S. Treasury started issuing floating-rate notes with two-year maturities in January 2014. Investors receive interest payments on a quarterly basis. Rates are tied to the most recent 13-week Treasury bill auction and reset weekly, so investors are paid more as interest rates rise and less as they fall.

Note: Bonds redeemed prior to maturity could be worth more or less than their original cost, and investments seeking to achieve higher yields also involve a higher degree of risk. Interest payments are taxed as ordinary income. Treasury bond interest is subject to federal income tax but exempt from state and local income taxes.