Bond Yields Around a First Rate Hike September 2, 2014

Last week’s Federal Reserve (Fed) news was a reminder that the Fed remains on course to raise interest rates about one year from now. The release of minutes from the July 29 – 30, 2014, Fed meeting and Fed Chair Janet Yellen’s remarks at the Fed’s annual Jackson Hole Symposium were less market friendly than anticipated. The double dose of new information from the Fed was a modest disappointment for bond investors who expected a more market-friendly tone. Bond markets remain mispriced for an eventual Fed rate hike, and last week’s rise in high-quality bond yields was a reminder of the interest rate risk facing bond investors.

A rate hike remains about one year away, according to both Fed guidance and interest rate futures markets, but it still raises the question of when bond markets will move forcefully in response to Fed interest rate hikes. Yields have declined for most bonds, year-to-date, but expectations for higher interest rates have not wavered.

When Will Rates Rise?

So when will bond yields really move in response to Fed rate hikes? Over the last 20 years, bond yields began to increase approximately four to six months ahead of the Fed’s first interest rate increase [Figure 1]. The 2-year Treasury note is among the most sensitive to Fed changes to the fed funds target rate and therefore is a useful guide to market reaction.

A steadier rise in interest rates occurs once the first rate hike has passed, but in 1994, that steady rise began roughly two months before the first increase. Figure 1 shows the number of trading days, so adding back weekends gets us to calendar days and the four- to six-month period mentioned above.

The reaction among longer-term bonds, such as the 10-year Treasury, is similar but not identical. In 1994, the reaction in the 10-year yield came closer to three months prior to the Fed’s first rate hike, while in 1999 and 2004, the reaction came similarly four to six months before [Figure 2]. Like the 2-year yield, the rise in the 10-year yield was steadier just after the first rate increase in 1994 and 1999, but in 2004, a 1.0% rise in the 10- year yield was constrained to a period just before and after the first rate hike.

In 2004, the 10-year Treasury yield began to decline again despite ongoing Fed rate hikes leading a befuddled Alan Greenspan to famously label it a “conundrum.” Intermediate and long Treasury yields, however, resumed their rise in 2005, in response to continued Fed interest rate hikes before peaking in 2006.

Another takeaway from Figure 2 is that the rise in 10-year yields was more limited in time span. In 1999 and 2004, the 10-year yield peaked within one to three months after the first rate increase — a reminder that longer-term bonds are less influenced by the Fed and more by economic growth and inflation expectations. In 1994, the 10-year Treasury yield peaked 10 months after the first rate hike — perhaps a reflection of an aggressive and quick Fed rate hike schedule (which is not expected in the current environment) and the Fed continuing to emphasize a go-slow approach.

Caveat Emptor

Of course, every historical period is unique, reaction may not follow historical form, and investors need to beware. The prevailing environment is quite different from others and involves a range of Fed stimulus that may be halted or reversed as the Fed gradually attempts to normalize policy. Bond purchases are expected to end in October 2014, and the Fed may eventually change its guidance from being on hold for a “considerable” period to signaling that a rate hike is drawing near. Both events may act as a catalyst to higher yields.

Other Fed tools, such as paying interest on excess bank reserves and the reverse repurchase facility, cloud potential market reaction. Additionally, the latest indication from the Fed is that it may maintain an overnight interest rate range, rather than set a specific rate, which may soften the potential market reaction.

We believe the rise in interest rates may begin sooner in anticipation of an interest rate hike. Bond valuations, although off the peak of early May 2013, remain very expensive by historical comparison, and the bond market has already priced in a Fed that may take longer than anticipated to raise interest rates. Along with lower yield levels compared with history, this makes the bond market vulnerable to rising rates. Timing such a move is very difficult, even with history as a guide. We favor a defensive stance in the bond market capitalizing on year-to-date strength and positioning with short to intermediate bonds to protect against the threat of rising interest rates.

 

 

IMPORTANT DISCLOSURES

The opinions voiced in this material are for general information only and are not intended to provide or be construed as providing specific investment advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly. The fast price swings of commodities will result in significant volatility in an investor’s holdings. International investing involves special risks such as currency fluctuation and political instability and may not be suitable for all investors.

Not FDIC/NCUA Insured | Not Bank/Credit Union Guaranteed | May Lose Value | Not Guaranteed by any Government Agency | Not a Bank/Credit Union Deposit

Member FINRA/SIPC

 

Why Own Bonds? January 21, 2014

Strong equity market performance in 2013 and still-low yields may cause investors to overlook the fact that bonds can still serve as an effective diversification tool. Following a year in which stocks returned 30% and bonds posted their worst return since 1994*, investor sentiment for stocks remains positive while bond sentiment is poor. The divergence in sentiment is evident in actual investment dollars. Inflows into stock mutual funds totaled $168 billion in 2013 versus a rare outflow for bonds, which totaled $82 billion. Our 2014 forecast calls for 10% to 15% returns for stocks and another challenging year for bonds with returns roughly flat^{^.}

The case for stock investing is strong but pullbacks can arrive without warning. As mentioned in our

Outlook 2014, we expect more volatility this year. In 2013, the stock market experienced only one brief pullback of just over 5%. Historically such calm is rare. Looking beyond 2014 the case for stocks over bonds is compelling, but for investors with shorter-term horizons protection against an equity market sell-off is prudent. After all, the average annual peak-to-trough decline in the S&P 500 from 1960 to 2013 has been 16%, and pullbacks can arrive without warning. Investors need to be prepared and bonds can help provide a buffer.

A look back at prior stock market pullbacks illustrates how bonds have historically provided good diversification benefits. Figure 1 shows all equity market pullbacks of 5% or more lasting three weeks or more over the past 10 years and the corresponding return for stocks and high-quality bonds. Figure 1 also illustrates the hypothetical return of a balanced 60% stock/40% bond portfolio and the dampening impact bonds can have on stock weakness. During stock market pullbacks in excess of 5%, bonds outperformed stocks on average by a double digit margin, a significant difference. Excluding the historic mid-2008 to early-2009 sell-off, the performance differential narrows but is still notable at a 9.6% advantage in favor of high-quality bonds.

In a few cases, both stocks and bonds declined together. This is a troubling outcome and reflects a failure of diversification, but it is rare. Still, bonds managed to outperform stocks on those occasions. In 2008, high-quality bonds provided a buffer but not without volatility, as investment-grade corporate bonds declined for the year and even high-quality mortgage-backed securities (MBS) suffered brief declines. While not all segments of the bond market perform similarly every time, an allocation to high-quality bonds has proven effective at offsetting stock market weakness.

Not About Yield

Today’s low-yield environment does not negate the diversification potential of bonds. During 2012, the stock market suffered two pullbacks greater than 5%, and bonds rose more than 1% over each period. The 10-year Treasury yield varied between 1.4% and 1.9% during the 2012 equity market sell-offs, much lower than today’s level.

In fact, during each stock market pullback in Figure 1 bond market performance is fairly consistent, averaging 1%, despite varied levels of interest rates. Two of the bond market’s strongest gains during stock market sell-offs occurred in 2010 and 2011, a post-recession period in which yields had already declined sharply.

Over short-term periods, price movement, not interest income, is the primary driver of bond performance. Interest income accrues slowly and although the primary driver of long-term bond returns, price changes, up or down, often overwhelm the impact of interest income over short periods of time. Therefore, a low-yield environment does not preclude bonds acting as a diversification tool.

Pension Buyers

Pension plans represent another investor group that can use bonds to address a specific objective. Pension investors, who have a very long time horizon and are therefore less sensitive to interest rate movements, use bonds to offset their long-term liabilities. Robust equity market gains in 2013 improved pension funding ratios broadly and reduced the need to take on additional risk to achieve investment goals. Following a year in which equities gained 30%, pension buyers took advantage of long-term Treasury yields near 4% and long-term corporate bond yields above 5% to better balance the risk-reward profile of their investment portfolios [Figure 2]. Pension buying, which has been a steady source of demand so far in 2014 and one reason why bonds are off to a good start, illustrates another way in which bonds can address specific investor objectives.

Conclusion

Low yields will likely translate into lower long-term bond returns, and therefore the hurdle for stock investors to beat bond performance over the long term is lower. However, for investors with shorter horizons or those simply unwilling to endure stock market swings, bonds can play a diversification role even in today’s low-yield environment. In conjunction with sectors that historically hold up better against rising rates, such as high-yield bonds and bank loans, an allocation to core bonds makes sense to help protect against potential stock market weakness.

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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. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance reference is historical and is no guarantee of future results. All indices 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. Past performance is no guarantee of future results.

This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.

The economic forecasts set forth in the presentation may not develop as predicted and there can be no guarantee that strategies promoted will be successful.

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

Stock and mutual fund investing involves risk including loss of principal.

Corporate bonds are considered higher risk than government bonds but normally offer a higher yield and are subject to market, interest rate and credit risk as well as additional risks based on the quality of issuer coupon rate, price, yield, maturity and redemption features.

Mortgage-backed securities are subject to credit, default risk, prepayment risk that acts much like call risk when you get your principal back sooner than the stated maturity, extension risk, the opposite of prepayment risk, and interest rate risk.

Treasuries are marketable, fixed-interest U.S. government debt securities. Treasury bonds make interest payments semi-annually, and the income that holders receive is only taxed at the federal level.

Government bonds and Treasury bills are guaranteed by the US government as to the timely payment of principal and interest and, if held to maturity, offer a fixed rate of return and fixed principal value.

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INDEX DESCRIPTIONS

The Barclays Aggregate Bond Index represents securities that are SEC-registered, taxable, and dollar denominated. The index covers the U.S. investment-grade fixed rate bond market, with index components for government and corporate securities, mortgage pass-through securities, and asset-backed securities.

The Standard & Poor’s 500 Index is a capitalization-weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.

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This research material has been prepared by LPL Financial.

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

Not FDIC/NCUA Insured | Not Bank/Credit Union Guaranteed | May Lose Value | Not Guaranteed by any Government Agency | Not a Bank/Credit Union Deposit

Member FINRA/SIPC

2014 Fixed Income Outlook December 3, 2013

In 2014, interest rates are likely to continue to move higher and bond prices lower in response to improving economic growth, reduced Federal Reserve (Fed) bond purchases, and the likelihood of an interest rate hike in 2015. Even though a Fed rate hike is a 2015 event, bond prices are likely to decline and yields increase as valuations remain expensive to historical averages and forward-looking markets prepare for a rate hike. We view the start of interest rate hikes as more important than the pace of tapering, but tapering will mark the first step in bond prices and yields returning to historical norms. We see a defensive investment posture focused on less interest rate sensitive sectors as the most prudent way to invest in 2014.

Yielding to Growth

Longer-term bond yields have historically tended to track the change in gross domestic product (GDP) growth absent the influence of Fed actions. Our expectation for a 1% acceleration in U.S. GDP over the pace of 2013 suggests a similar move for the bond market. This would prompt a rise in the yield on the 10-year Treasury from around 2.75% as of mid-November 2013 to about 3.25% to 3.75% in 2014.

On the Horizon

While investors may see the Fed end direct involvement in the bond market in 2014 as the bond-buying program comes to a close, the Fed may make its presence felt again in 2015 with a series of rate hikes. The expectation for rate hikes in 2015 may also lead to rising pressure on bond yields in 2014. Each period of Fed interest rate hikes is different, but by evaluating key metrics such as short-term Treasury yields, the shape of the yield curve, and inflation-adjusted yields prevalent at the start of prior Fed rate hikes, we can approximate the trajectory of yields in 2014 as the market braces for a potential interest rate hike in 2015.

Given the Fed’s current guidance for a mid-2015 start to interest rate hikes, supported by our outlook for stronger GDP and job growth in 2014, we may expect at least an 18-month path of reduced Fed involvement in the bond market from around the start of 2014 to mid-2015. This reinforces the fundamental case for the 10-year Treasury yield rising by 0.5% to 1.0% as yields rise to more “normal” valuation levels that would translate to a 10-year Treasury yield at the end of 2014 of 3.25% to 3.75%. Total returns may be roughly flat under that scenario  [Figure 1].

It is possible that yields could increase by 1.0% to 3.75% should inflation-adjusted yields return to more normal levels. Under that scenario, high-quality bond total returns would be negative, as indicated by Figure 1.  However, we see a move of this magnitude as less likely unless the markets expect an earlier start to Fed rate hikes. Instead, we think it is more likely the Fed may wait longer than mid-2015 to raise interest rates, which supports a more modest rise in the 10-year of 0.50% to 0.75%.

A number of factors indicate yields may rise less than our forecasts, and this is the primary risk to our bond outlook.

• Low Inflation. Inflation is an enemy of bondholders since it makes fixed payments worth less over time. While inflation is likely to pick up modestly in 2014, fortunately, it is likely to remain historically low. Bond valuations may therefore remain historically expensive. The lower the pace of inflation, the less bond yields will need to rise in response.
• Disappointing growth.  Slower-than-expected growth may reinforce the low inflation environment and delay the timing of eventual Fed rate hikes — both of which are positives for bond prices. Should the economy grow at a slower pace than anticipated in 2014, bond prices may similarly prove more resilient.
• Fed delays.  Our interest rate forecast is based upon the Fed gradually tapering bond purchases in 2014 and market participants’ expectation for a potential interest rate hike in June 2015. If these are pushed back, yields may rise less than our base forecast and bond prices may prove more resilient. Low single-digit returns may result if it becomes clear the Fed may wait longer than mid-2015 to raise interest rates.

Stay in the Middle

Among high-quality bonds we prefer intermediate-term bonds, which possess far less interest rate risk compared with long-term bonds [Figure 2].  The yield curve remains relatively steep today. A positive factor for intermediate-term bonds is that they include the steepest portion of the yield curve. A yield curve is a chart of bond yields from the shortest-maturity issues to the longest-maturity ones. The steepest point is that which offers the biggest increase in yield per additional increase in term.

While short-term bonds offer the least interest rate risk, their low yields make them less attractive. We believe intermediate-term bonds possess a better combination of interest rate risk mitigation and reward in the form of yield under a range of outcomes.

Intermediate-term bonds have the ability to generate modestly positive returns despite a fair rise in interest rates. Importantly, given their position on the yield curve, intermediate-term bonds can also provide some defensive properties to a portfolio [Figure 3].  Immediate-term, high-quality bond returns turn negative with a 1.0% rise in interest rates — just above the high end of the most likely range we expect for intermediate-term bonds in 2014. However, they can produce mid-single-digit gains if interest rates are unchanged or even decline slightly — driven by disappointing economic growth or a negative event causing investors to take a temporary defensive stance. In that event, intermediate-term bonds may provide a gain offsetting losses in the event of a stock market pullback — a key reason for holding bonds in a portfolio.

Harvesting Yield

A rising interest rate environment presents a challenge to bond market investors. Investors must seek to minimize interest rate driven losses and at the same time focus opportunistically on sectors that have traditionally produced gains during rising rate environments.

High-yield bonds and bank loans are two sectors that have historically proven resilient and often produced gains during periods of rising interest rates. In 2013, both sectors were among the leaders of bond sector performance during a year of higher interest rates.

High-yield bonds and bank loans are attractive bond sectors for 2014. Deteriorating credit quality and rising defaults are the key risks to investors in these lower-rated bonds, but we believe these risks will be manageable in 2014 as growth picks up. The global speculative default rate was a low 2.8% at the end of October 2013 — well below the historical average of 4.5%. Moody’s forecasts a low default environment to persist through 2014, a forecast we agree with given the limited number of maturing bonds in 2014. In addition to a low default environment, both high-yield bonds and bank loans remain supported by good fundamentals. Company leverage has increased over recent quarters, but the cost to service that debt remains quite manageable with interest coverage near post-recession highs.

High-yield bonds and bank loans are likely to produce low- to mid-single-digit returns in 2014. High-yield bond valuations are more expensive heading into [Figure 4]. As 2014 progresses, yield spreads may increase as investors begin to demand greater compensation for a potential  increase in defaults in 2015. Bank loans may also be impacted by investors bracing for higher defaults, but less than high-yield bonds due to their shorter-term nature and higher  seniority.

Among high-quality bonds we favor investment-grade corporate and municipal bonds. Investment-grade corporate bonds are likely to be impacted by rising interest rates, but still yield, on average, 1.3% more than comparable Treasuries. In a rising rate environment, interest income can be a buffer against price declines associated with rising interest rates. The higher yield potential of investment-grade corporate bonds, which remain supported by good credit quality fundamentals, may therefore be able to provide better protection than Treasuries.

Corporate bond sectors, both investment-grade and high-yield, have historically provided better protection against rising interest rates [Figure 5].  During periods of rising Treasury yields, corporate yields tend to rise less and corporate bond prices have been more resilient.  Figure 5 illustrates how the yield differential, or spread, between Treasuries and  investment-grade corporate bonds and high-yield bonds has generally narrowed when Treasury yields rose. Since 2000, investment-grade corporate bond yield spreads have narrowed in all but two periods of rising Treasury yields and all but one for high-yield bonds.

Among high-quality bonds, we also find municipal bonds attractive, favoring intermediate-term rather than traditional long-term municipal bonds.

International Debt

Emerging market debt (EMD) is another way to add higher income generating potential to portfolios. In general, EMD issuers have lower debt burdens and stronger economic growth than their developed market peers. In addition, valuations are attractive as 2013 winds down with an average yield spread of 3.6% to comparable Treasuries, near the upper end of a four-year range. Better valuations set the foundation for a better 2014, following a difficult 2013. However, not all EMD issuers are alike. In the face of relatively sluggish global demand in recent years, some emerging market countries have relied on extraordinary liquidity provided by the world’s central banks to grow their economies at the cost of running current account deficits as they increasingly borrow to import more than they export. As global credit conditions tighten and developed market bond yields rise, some EMD issuers have suffered as investors find more attractive yields in more financially secure markets. As these EMD issuers adjust to the lessened liquidity provided by central banks, they become increasingly attractive. Emerging market debt is increasingly attractive in 2014, but we remain cautious on developed foreign bond markets given weak growth and unattractive valuations.

Opportunities in a Less Liquid Market

Like 2013, 2014 may also provide investors with opportunities created by volatility. In 2013, the 10-year Treasury yield fell as low as 1.6% and also rose as high as 3.0% — a remarkably wide range given the steady and sluggish pace of economic growth and lack of abrupt changes by the Fed. Although these movements may seem dramatic in a historical context, they may become the norm as recent financial regulations discourage traditional market-making firms from participating in the bond market. As a result, these less liquid markets can experience sharp swings up or down and temporarily take prices and yields beyond levels warranted by fundamentals. Tactical investors may harvest opportunities that could arise in a low-return, volatile market. This may be experienced more dramatically in less liquid markets, such as emerging market debt and municipal bonds among others.

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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. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results. All indexes are unmanaged and cannot be invested into directly.

The economic forecasts set forth in the presentation may not develop as predicted and there can be no guarantee that strategies promoted will be successful.

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

Gross Domestic Product (GDP) is the monetary value of all the finished goods and services produced within a country’s borders in a specific time period, though GDP is usually calculated on an annual basis. It includes all of private and public consumption, government outlays, investments and exports less imports that occur within a defined territory.

Government bonds and Treasury bills are guaranteed by the U.S. government as to the timely payment of principal and interest and, if held to maturity, offer a fixed rate of return and fixed principal value. However, the value of fund shares is not guaranteed and will fluctuate.

Treasuries are marketable, fixed-interest U.S. government debt securities. Treasury bonds make interest payments semi-annually, and the income that holders receive is only taxed at the federal level.

International and emerging market investing involves special risks such as currency fluctuation and political instability and may not be suitable for all investors.

Preferred stock investing involves risk, which may include loss of principal.

High-yield/junk bonds (grade BB or below) are not investment grade securities, and are subject to higher interest rate, credit, and liquidity risks than those graded BBB and above. They generally should be part of a diversified portfolio for sophisticated investors.

International and emerging market investing involves special risks such as currency fluctuation and political instability and may not be suitable for all investors.

Preferred stock investing involves risk, which may include loss of principal.

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INDEX DESCRIPTIONS

The Barclays Capital Aggregate Bond Index is an unmanaged market capitalization-weighted index of most intermediate-term U.S. traded investment-grade, fixed rate, non-convertible and taxable bond market securities including government agency, corporate, mortgage-backed, and some foreign bonds.

The Barclays Capital High Yield Index covers the universe of publicly issued debt obligations rated below investment-grade. Bonds must be rated below investment-grade or high-yield (Ba1/BB+ or lower), by at least two of the following ratings agencies: Moody’s, S&P, Fitch. Bonds must also have at least one year to maturity, have at least $150 million in par value outstanding, and must be US dollar denominated and nonconvertible. Bonds issued by countries designated as emerging markets are excluded.

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This research material has been prepared by LPL Financial.

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

Not FDIC/NCUA Insured | Not Bank/Credit Union Guaranteed | May Lose Value | Not Guaranteed by any Government Agency | Not a Bank/Credit Union Deposit

Member FINRA/SIPC