The State of the Bond Market – A “Boring” Asset Class in Perspective
■ After the 2008–2009 Global Financial Crisis, bond markets saw years of low and relatively stable interest rates.
■ Over the last year, however, we have seen a dramatic rise in interest rates and a “flattening” of the yield curve – as the spread between long- and short-term bond yields has narrowed.
■ In such an environment, there is significant pressure on bond returns, and we advise investors to carefully manage and monitor the risks they are taking in their fixed-income investments.
Investors often focus their attention on the equity markets and the performance of their stock holdings, putting less thought into the generally more stable fixed-income allocations in their portfolios. This is not entirely irrational – long-term equity returns throughout history have been significantly higher than fixed-income returns (a concept called the “equity risk premium”). However, fixed income serves a critical role in many portfolio strategies: reducing overall volatility, providing liquidity, and diversifying risks.
To that end, in this paper we will examine the current environment for bond investors as we enter the autumn of 2018. We have seen one of the sharpest rises in interest rates in over a decade. As interest rates rise, prices of most bonds fall, and investors may feel less secure with a previously “safe” asset class. In the first seven months of 2018, the US total fixed-income market (as measured by the Bloomberg Barclays US Aggregate Bond Index) fell by 1.6%. In a volatile environment for a normally stable asset class, we believe that investors should look to optimize the risks they take in the fixed-income market.
Rising Rates and Flatter Yield Curves
As mentioned earlier, over the last 18 months the US has experienced the sharpest interest rate increases since the 2008–2009 Financial Crisis. The yield on 1-month US Treasury bills has climbed from roughly 0% (for seven years) to nearly 2% (see Exhibit 1), causing many investors and market observers to become concerned about the pressure this will place on the broader bond market. The yield of short-term T-bills is in many ways the foundation of many financial instruments, valuation calculations, and the interest-rate environment generally. As these rates rise, they impact everything from the cost of higher-risk bonds to residential mortgages, auto and commercial loans, and bank accounts.