In February, the story of fixed income was told from a complex screenplay, with oil pricing, FOMC commentary, Brexit uncertainty, banks’ energy exposure, and economic data all receiving award nominations for “Most Worrisome to Market Participants.”
The Trouble with the Curve: Rate Hike Considerations
Many fixed income investors are concerned about the recent rise in interest rates being widely reported in major financial news. However, while “rates are rising” is an oft-mentioned blanket statement about today’s financial environment, the increase in rates does not typically occur homogeneously or in a parallel fashion. In this blog post, we discuss some of the complexities of rising rates that could create relative value opportunities.
Typically when rates rise, the U.S. Treasury curve does not rise evenly across maturities. When the Fed has raised rates, the move higher in yields has historically tended to impact shorter-maturity bonds more than longer. This is partly because the Fed’s open market operations are performed on short-term rates and have a more-direct impact on that part of the curve. By contrast, longer maturities are influenced by a variety of other levers, such as inflation expectations, future rate expectations and term premiums (Figure 1).
Federal Reserve rate-hike cycles since the 1990’s have seen the yield curve “bear flattening,” meaning that shorter maturities rose more than longer maturities. Figure 2 shows the change in interest rates during the current hiking cycle. While the curve has flattened, we note that it has not flattened enough to lead to an inverted curve, which occurs when shorter maturities have higher yields than longer maturities.
Given the current rising rate environment, we understand that investors are concerned about total return in their fixed income holdings and may want to shorten their duration exposure. However, it is important to also consider the curve’s behavior across maturities as rates rise, because this has important implications for fixed income returns.
Figure 3 shows that over the past four rate-hike cycles, the 1-5 Year Treasury Index has not materially outperformed the 1-10 Year and, in fact, has lagged the return of the 1-10 in the 04-06 cycle and in the current cycle, to date. This illustrates that “going short” through the Fed’s rate hike may not lead to as much of a gain as some market participants expect.
In addition, we note that activity to shorten duration typically involves trading costs and could have tax implications from taking gains or losses, which further dilutes the potential benefit of shortening. While some market participants may aim to time when rate hikes are ending to then return to a longer duration, this effort is often unsuccessful.
The current rate-hike cycle is different for many reasons. Bond markets are grappling with the end of global quantitative easing, which is taking large government buyers out of the market and putting upward pressure across maturities – particularly the long end. On the other hand, inflation remains tepid despite low unemployment and jobless claims. To manage potential curve volatility, investors can consider:
- Active management: In a passive bond ladder, one is investing in certain parts of the curve based solely on the predetermined laddered structure, while active managers are typically more thoughtful about allocating capital to maximize risk-adjusted return. Bond strategies such as barbells could be beneficial in periods of curve flattening.
- Separate accounts: By owning bonds directly and holding to maturity, investors are able to take advantage of bond contractual agreements to receive their cash flows on each bond and the yield-to-maturity when the bond was purchased, independent of the market.1 Total return investors can also benefit from separate accounts because there is no dynamic of selling to meet redemption demands of other investors, which could be performed suboptimally for some fund shareholders.
- Brace for a “new normal:” We believe that sentiment is changing from the bond bull market of the past three decades, and investors must now consider a “new normal” with rates trending higher over the coming years, although we acknowledge that rates may rise and fall as the business cycle moves forward. However, we think that still-low inflation and moderate consumer spending suggest that rates will likely rise at a measured pace. We look forward to discussing the potential impacts of the current cycle with our clients.
 Assuming no default on the bond.
DISCLAIMER: The opinions and views expressed are those of Breckinridge Capital Advisors, Inc. They are current as of the date(s) indicated but are subject to change without notice. Any estimates, targets, and projections are based on Breckinridge research, analysis and assumptions. No assurances can be made that any such estimate, target or projection will be accurate; actual results may differ substantially.
Nothing contained herein should be construed or relied upon as financial, legal or tax advice. All investments involve risks, including the loss of principal. An investor should consult with their financial professional before making any investment decisions.
Some information has been taken directly from unaffiliated third party sources. Breckinridge believes such information is reliable, but does not guarantee its accuracy or completeness.
Any specific securities mentioned are for illustrative and example only. They do not necessarily represent actual investments in any client portfolio.