Investment Grade Fixed Income In a Low Interest Rate Environment

As we enter 2015, investors anticipate that the Federal Reserve (Fed) will begin raising the Fed Funds rate sometime during the second half of the year. While these predictions may come true, interest rates have actually begun the year by tumbling lower. In the first two weeks of January, rates have fallen across the curve. Most notably, the 30-year Treasury yield dropped to an all-time low of 2.37%, after ending 2014 and 2013 at 2.75% and 4.00%, respectively. A number of factors have contributed to this sustained low-rate environment, including weak global growth, low inflation and the strong US dollar. While interest rates hover at very low levels, many investors believe that US Treasuries offer a safe and attractive investment option when compared to global alternatives. At IR+M, we do not predict how interest rates will behave or when they will change, but we do acknowledge that investors should assess why they own bonds and how their investments will change in a rising rate environment. Below, we have outlined three key themes that we believe address how investors should consider these challenges.

Bonds Play a Crucial Role in Asset Allocation Decisions

• Asset allocation decisions are driven by risk and return objectives in tandem with investor constraints
  • An allocation to fixed income provides diversification and liquidity along with principal protection and steady cash flow
  • The role of fixed income varies across investors and is based on liability funding requirements, liquidity needs, the desire for yield, and tax status, among other factors
    • Short duration strategies may serve as a cash alternative
    • Long duration bonds are often used to hedge pension liabilities or as a deflation hedge
  • These motivations for including fixed income have created strong demand at a time when net supply levels are constrained
    • Bonds that offer additional yield over Treasuries (spread product) may provide protection from rising rates given higher all-in yield levels

Most Investors Will Benefit From Rising Rates

• If an investor’s time horizon is longer than the duration of the portfolio, a rising rate environment is beneficial longer term
  • The graph on the right shows a hypothetical scenario of two interest rate paths
  • In a rising rate environment, portfolio value decreases in the short-term, but higher reinvestment rates improve portfolio returns over time
  • In a declining rate environment, portfolio value increases in the short-term, but lower reinvestment rates detract from long-term returns
• Since 1994, there have been three distinct time periods of increasing Fed Funds rates
  • The magnitude and duration of each period of rising Fed Funds rates was different
  • Despite increased price volatility, the cumulative total return of the Barclays Aggregate Index remained positive during each period and for the year following the rate rise
• Past periods may not be indicative of future returns as yields are currently at a much lower starting point

Active Management Can Identify Opportunities to Add Value Versus Highly-Concentrated Indices

• Fixed income indices have accumulated significant weights in securities with explicit and implicit government guarantees this has been driven by recent government policy initiatives and high federal budget deficits
  • For passive investors, these concentrated sector weights result in significant exposures to sectors that may be considered overvalued given current relative value opportunities
  • Active managers can broaden the opportunity set and invest in sectors that are under-represented and/or not included in benchmark indices
  • The significant allocation to fixed-rate mortgage securities in the Barclays Aggregate Index may cause the duration of the Index to extend in a rising rate environment as mortgage holders are less likely to refinance and/or prepay in this environment
    • IR+M seeks to invest in securities that will help guard against this potential outcome
  • As beta (market return) becomes a smaller portion of total return, the ability of a manager to add alpha (return over the benchmark) is becoming an increasingly crucial portion of total returnTreasuries and fixed-rate mortgage securities that have an implicit government guarantee make up approximately 36%and 28% of the Barclays Aggregate Index, respectively

At IR+M, we offer a variety of strategies that will perform differently in rising interest-rate environments. Our focus on bottom-up security selection enables us to be nimble and take advantage of opportunities across fixed income sectors as they arise. We strive to work with our clients to understand what role fixed income plays in their overall asset allocation goals and what solution works best for their needs.

¹Source: Bloomberg

²Scenario analysis assumes a 5-year duration, 2% starting yield, and 1.5% instantaneous, parallel interest rate shift. Shaded area indicates instantaneous shift.

³Source: Bloomberg; Estimates for future year-end target Federal Funds Rates based on median Federal Open Market Committee (“FOMC”) member forecasts

⁴Source: Barclays

The views contained in this report are those of IR+M and are based on information obtained by IR+M from sources that are believed to be reliable.  This report is for informational purposes only and is not intended to provide specific advice, recommendations for, or projected returns of any particular IR+M product. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission from Income Research & Management.