Viewpoints

July 26th, 2018 | by

Investing in Bonds in a Time of Rising Rates and a Flattening Yield Curve

  • This year has been marked by losses in most bonds and a dramatic flattening of the interest-rate yield curve.
  • Investors should focus on the defensive and risk-management roles of bonds in a diversified portfolio.
  • We prefer short-term, high-quality bonds for their relatively high risk-adjusted returns and hedging quality in times of crisis.

The first half of 2018 wasn’t kind to bond investors. In the face of rising interest rates, prices of most types of bonds have tumbled. For instance, year-to-date to July 10, the Bloomberg Barclays Aggregate Bond Index fell 1.5%. Some investors in this ‘safe’ asset class, fearing further rate increases, are even considering abandoning bonds. I thought now is an opportune time to discuss our thinking on this important asset class and its role in an investor’s portfolio.

The past 12 months have brought the sharpest rises in interest rates since the 2008-2009 Financial Crisis. Some factors behind the trend include a succession of Federal Reserve Board rate hikes (which affect short-term more than long-term interest rates), relatively strong economic growth, a solid job market, and higher inflation. For instance, in the year to July 12, the yield on 2-year Treasury notes surged by 121 basis points to 2.59%.

The other notable trend is that not all rates are rising in sync, which has resulted in a dramatic flattening of the yield curve, as demonstrated in Exhibit 1. For instance, while the 2-year yield was rising 125 basis points, the yields on 10- and 30-year Treasuries increased by only 54 and 7 basis points over the past year, respectively. A normal yield curve is upward sloping, with longer-dated bonds yielding much more than shorter-duration bonds. But with 10-year Treasuries now yielding only 26 basis points more than 10-year notes, the yield curve is very flat and close to inverting, or becoming downward sloping. We don’t make interest rate or economic forecasts, but I would note that, historically, an inverted yield curve in the bond market has been a highly accurate warning sign of a looming recession.

 

Steadying Force

I see fixed income as playing multiple roles in investment portfolios. Bonds generate income, obviously, which is particularly important for retirees. But they are also an invaluable risk-management tool for reducing total portfolio volatility and providing liquidity. We believe that investors are better compensated for taking risk in equities than in fixed income; thus, I prefer a fixed-income strategy dominated by short-term, high-quality government bonds (including municipals and sovereign foreign debt) that are less sensitive to rising interest rates and often perform well during bouts of turbulence in bond and equity markets. For example, during the January 1 to July 10, 2018 period, short-term Treasuries gained 0.05% while corporate bonds lost 2.53% (as measured by the Bloomberg Barclays US Credit Index) and long-term Treasuries fell 2.7%. As illustrated in Exhibit 2, compared to other bond asset classes, short-term US government bonds have a relatively low return but the highest return on a risk-adjusted basis (i.e., Sharpe Ratio) due to very low volatility.

But where the defensive strength—or hedging nature–of short-term, high-quality government paper really shines is during severe market drawdowns or financial crises. Unfortunately, these unpleasant periods, when most asset classes seem to plunge in unison, come with the territory of investing long-term in ‘risky’ assets such as equities. During the turmoil and the inevitable ‘flight to safety,’ short-term Treasuries tend to be resilient, lowering the portfolio’s volatility and providing valuable liquidity.

Let’s take the traumatic example of the 2008-2009 Global Financial and stock market collapse. Exhibit 3 speaks to the flight-to-safety quality of short and intermediate US Treasuries during the stock market meltdown. Notice how high-yield (or ‘junk’ bonds), which have a higher correlation with equities than with investment-grade bonds, also headed south when the going got tough. Exhibit 4 provides a more complete picture of how well those short and intermediate government bonds performed during the crisis when compared to other asset classes in a diversified portfolio. Note that preferred stocks, which some investors view as a high-income substitute for bonds, plunged with common stocks, and that short-term Treasuries also proved to be a far more effective (and cheaper) hedge than ‘hedge funds.’

Conclusion

At a time when interest rates are rising and the yield curve is flattening, investors should consider whether their bond exposures and strategy are appropriate. We prefer a ‘boring’ approach to fixed income, investing in short-term, high-quality government bonds, which play an important risk-management role in a diversified portfolio and increase the chances that investors will stick with volatile asset classes such as equities during times of crisis.

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