Which fixed-income strategies work best in different interest-rate environments?
Predicting the future of long-term interest rates has always been a tricky proposition.
Unlike short-term rates, which are heavily influenced by a central bank’s monetary policy, longer-term yields are driven by market dynamics that are notoriously difficult to forecast. That said, there are a few principles that can offer clues. At the most fundamental level, it’s safe to say that one of the things the prices of bonds reflect is demand: Prices generally rise when demand is strong and prices fall when demand is soft. Yields—which move in the opposite direction of prices—can therefore be thought of as one gauge of aggregate investor demand.
But if demand drives changes in yields, what drives changes in demand?
Different factors affect different segments of the bond market in particular ways and in varying degrees. Inflation expectations, for example, tend to have a significant impact on the Treasury market. Expectations about the health of the economy, on the other hand, often have an outsize effect on the high-yield corporate bond market. The bottom line is that investor demand for different types of bonds isn’t uniform; that’s why bond prices and yields don’t always move in lockstep across various segments of the bond market.
What will the bond market do next? Examining historical patterns of performance
Let’s look at some actual data. We examined the performance of three segments of the bond market—high-yield bonds, investment-grade corporate bonds, and 10-year U.S. Treasuries—to look at how they performed over the past decade. We’ve also divided up the past 10 years into three different environments: periods of falling rates, rising rates, and periods where rates generally moved sideways.
As one might expect, in periods of falling yields, U.S. Treasuries performed the best, and when rates rose, they posted the heftiest losses. Treasuries’ performance, after all, is driven almost exclusively by rate movements, so this would make sense. High-yield bonds, meanwhile, did just the opposite, outperforming when rates rose and lagging when they fell.
What may be less apparent is why each of these three segments of the bond market performed the way they did when rates were rangebound—that is, when rates moved sideways. In these types of environments, high yield led the pack while Treasuries lagged. The same was true over the entirety of the past decade, and both of those facts point out another tenet of fixed-income investing: Income matters.
The total return of a bond is made up of two components: the income it generates and any price changes. The income a bond generates is, in fact, highly predictive of its total return over a five-year timeframe—and most of that total return is attributable to the income. One of the key takeaways here is that given a long enough window of time, higher-yielding securities more often than not have generated higher total returns.
Building a bond portfolio for today’s market
None of this is to suggest that credit risk is inherently preferable to interest-rate risk. High-yield bonds, like stocks, are geared toward the strength of the economy; adding them to an equity portfolio is essentially doubling down on a single source of risk. One of the main reasons to own bonds in the first place is to help diversify away from economic risks and to add ballast to an economically sensitive portfolio. But Treasury debt—particularly given the low starting yields and the prospect of rising long-term rates—has little to recommend it at the moment outside of acting as an insurance policy on the stock market.
We believe that the best approach to the bond markets is to diversify risks within a bond portfolio, tactically balancing between credit risk and interest-rate risks as market conditions change. We’ve looked primarily at two very different segments—Treasuries and corporate debt—but there are many types of debt in today’s diverse bond market. Asset- and mortgage-backed securities, for example, exhibit characteristics that are different from both the government and corporate bond markets. And foreign markets can add another source of diversification to a portfolio, offering a degree of insulation from the dynamics that drive performance in the U.S. market. As fixed-income managers, we view our job first and foremost through the lens of risk mitigation—seeking to build a portfolio that offers an attractive level of both income and diversification without taking on too much exposure to any particular source of risk. If we can do that, we believe we’re well positioned to offer competitive performance in a variety of interest-rate environments.
To learn more about fixed-income investing, visit our educational page.
10-year U.S. Treasuries are measured by the 10-Year Treasury Constant Maturity Index, published by the U.S. Federal Reserve and reported by Morningstar, which tracks the performance of a range of U.S. Treasuries, the maturities of which have been adjusted to the equivalent of a 10-year security. Investment-grade corporate bonds are measured by the Bloomberg Barclays U.S. Corporate Bond Index, which tracks the performance of U.S. investment-grade bonds in the U.S. corporate debt market. High-yield bonds are measured by the Intercontinental Exchange (ICE) Bank of America Merrill Lynch (BofA ML) U.S. High Yield Master II Index, which tracks the performance of globally issued, U.S. dollar-denominated high-yield bonds. It is not possible to invest directly in an index. Past performance does not guarantee future results.
The views expressed are those of the author(s) and are subject to change. No forecasts are guaranteed. This commentary is provided for informational purposes only and is not an endorsement of any security, mutual fund, sector, or index.
Diversification does not guarantee a profit or eliminate the risk of a loss.
Investing involves risks, including the potential loss of principal. Past performance does not guarantee future results.