How a Rate Rise Reminds Us Why We Invest in Fixed Income

Transcription

1 How a Rate Rise Reminds Us Why We Invest in Fixed Income While it s smart to stay current on the trajectory of rising interest rates, allowing them to change the way you think about your fixed-income investments is assigning them too much power. Like death and taxes, the reasons you should consider allocating a portion of your portfolio to fixed income should never go away. An examination of the historical performance of fixed income in the periods during and immediately following a rate rise has revealed a potentially more favorable outlook for investors who were committed to the longterm role that bonds typically play in a portfolio. Instead of spooking fixed-income investors, the stress caused by rising interest rates should remind us of the reasons why we invest in fixed income in the first place. 1

2 A Twist in the Rising Rates Plot Typically, news of rising rates is met by fixed-income investors with as much enthusiasm as a root canal. That s because when rates rise in the short term, bond prices generally fall and their value drops an unpleasant proposition to say the least. It s enough to make investors forget the reasons why they hold bonds in their portfolios and reconsider their longterm asset allocation choices. But the fixed-income/rising rates narrative could contain a surprise twist. First of all, not all types of fixed income react the same way when rates rise. Figure 1 below lists the periods of rising rates and the performance of various fixedincome assets during those periods. Figure 1: Rising Rates Can Affect Bond Returns Negatively Fixed-Income Returns During Periods of Rising Rates (%) Period Credit U.S. Suisse U.S. S&P U.S. U.S. 1-3 Corporate Leveraged Corporate 500 Aggregate U.S. Treasury U.S. MBS Year Government/ Municipal Bond Index 1 Index 2 Index 3 Investment Grade Bond Index 4 Credit Bond Index 5 Loan High-Yield Index 6 Bond Index 7 Bond Index 9 Index 8 7/2/79 2/26/ N/A N/A N/A /16/80 9/30/ N/A N/A /4/83 5/30/ N/A N/A /29/86 10/16/ N/A /15/93 11/7/ /18/96 7/5/ /5/98 1/20/ /7/01 4/1/ /13/03 6/14/ /2/05 6/12/ /17/08 6/13/ /18/08 4/5/ /6/10 2/8/ /22/11 10/27/ /19/11 3/19/ /25/12 12/31/ /30/15 6/10/ /11/16 3/11/ /5/16 12/30/ Average Median Minimum Maximum Data Sources: Morningstar, Ned Davis Research, 12/16 We defi ned a period of rising rates by a 20% change in the 10-year U.S. Treasury yield. Past performance is not indicative of future results. The performance shown above is index performance and is not representative of any fund s performance. Indices are unmanaged and not available for direct investment. Please see back page for index definitions. For illustrative purposes only. 2

3 Love The One You re (Investing) With So why should investors consider remaining faithful to fixed income as rates rise? Over time, as bonds mature and if they are reinvested at higher interest rates, their ability to generate income can increase. Moreover, the bonds interest payments could also be reinvested at higher rates. Because of this, if rates rise steadily and modestly over time, investors may be better off than if rates had remained at previously low levels. Figure 2 shows just how quickly bonds have recovered from the short-term price hit inflicted by a rise in interest rates. In 17 out of 19 periods, the year that followed a period of rising rates brought improved returns for the U.S. Aggregate Bond Index, with returns between less than 1% and 35%, and an average return of more than 10%. So if investors were able to deal with the short-term hit to their fixed-income holdings, they saw their returns recover in a short period of time. Playing the what-have-you-done-for-me-lately game with bonds can be a shortsighted proposition. When taken with the changeability of global economic conditions and market movements, it becomes clear that taking a long-term view to your fixed-income investments (and remembering their role in your portfolio) is a good way to maintain perspective in the face of short-term pressures. Figure 2: Bonds Have Tended to Recover Strongly After Rate Increases Fixed Income Returns During the Year After Rising-Rate Periods (%) Period U.S. Aggregate Bond Index U.S. Treasury Index U.S. MBS Index U.S. Corporate Investment Grade Bond Index U.S. 1-3 Year Government/ Credit Bond Index Credit Suisse Leveraged Loan Index U.S. Corporate High-Yield Bond Index Municipal Bond Index 2/26/80 2/26/ N/A N/A /30/81 9/30/ N/A N/A /30/84 5/30/ N/A /16/87 10/16/ N/A /7/94 11/7/ /5/96 7/5/ /20/00 1/20/ /1/02 4/1/ /14/04 6/14/ /12/07 6/12/ /13/08 6/13/ /5/10 4/5/ /8/11 2/8/ /27/11 10/27/ /19/12 3/19/ /31/13 12/31/ /10/15 6/10/ /11/16 12/30/ S&P 500 Index Average Median Minimum Maximum Data Sources: Morningstar, Ned Davis Research, 12/16 Past performance is not indicative of future results. The performance shown above is index performance and is not representative of any fund s performance. Indices are unmanaged and not available for direct investment. Please see back page for index definitions. For illustrative purposes only. 3

4 This Too Shall Pass Investors looking to dump their fixed-income investments as rates rise may want to take a step back to avoid missing the forest for the trees. It s important to remember that the short-term challenge of an interest-rate increase generally doesn t supersede the long-term reasons for holding bonds in your portfolio. One of those reasons is to serve as a potential counterbalance against volatility in the equity markets. Investors who maintain an allocation to fixed income can help offset declines in their equity holdings. And if you think diversification isn t a compelling enough reason to consider owning an asset class, talk with investors who were all in on equities in 2008 and discovered they were walking a high wire without a net as the winds of volatility started to gust. Figure 3 shows that during the seven negative calendar years for stocks that have occured since 1977, bonds have enjoyed positive returns. The other main reason to consider including fixed income in your portfolio is as a source of potential income. As mentioned earlier, bonds with varying levels of interest-rate sensitivity and credit risk have historically performed differently as rates rise. While the income-generating ability of traditional bonds can be compromised in the short term, other types of bonds may retain their incomegenerating abilities and may help offset short-term price declines. Figure 3: Bonds Have Historically Had Positive Returns When Stocks Have Been Down 30% 20% 10% 0% -10% -20% -30% -40% Stocks: S&P 500 Index Bonds: U.S. Aggregate Bond Index Source: Thomson Reuters, 12/16. PAST PERFORMANCE IS NOT INDICATIVE OF FUTURE RESULTS. THE PERFORMANCE SHOWN ABOVE IS INDEX PERFORMANCE AND IS NOT REPRESENTATIVE OF ANY FUND S PERFORMANCE. INDICES ARE UNMANAGED AND NOT AVAILABLE FOR DIRECT INVESTMENT. PLEASE SEE BACK PAGE FOR INDEX DEFINITIONS. FOR ILLUSTRATIVE PURPOSES ONLY. 4

5 ...But the Utility of Fixed Income Should Endure For example, high-yield bonds have historically tended to fare well during periods of rising rates. As Figure 1 shows, the U.S. Corporate High Yield Bond Index posted positive returns during rising-rate periods, averaging a return of 9.23% while the U.S. Aggregate Bond Index was almost entirely in the red with an average return of -1.44%. High-yield bonds generally have a higher credit risk, because of their lower credit rating than traditional bonds. But their interest-rate sensitivity can be lower because they typically offer higher yields than many other types of bonds. Bank loans have also tended to perform well when rates rise. They have a floating coupon that can adjust up or down on a monthly or quarterly basis as interest rates move up or down, which helps them generally have low interest-rate risk, though they are still subject to credit rate and liquidity risk. If you re still concerned about rising rates, there are shortduration bonds which tend to be less volatile because a rise in interest rates impacts the value of a two-year bond far less than that of a 20-year bond. Traditionally known for their tax advantages, municipal bonds have played an important role in helping investors diversify across many macroeconomic environments, including periods of rising rates. Figure 4 shows how municipal bonds have historically provided positive returns during periods of rising rates over more than 20 years. Figure 4: During Interest Rate Hiking Cycles, Municipal Bonds Delivered Positive Returns Annualized Average Monthly Return (January December 2016) 5.96% 5.02 % 2.02% Hiking cycle months Non-hiking cycle months All months Source: Morningstar, Federal Reserve. Based on the returns for the Municipal Bond Index. Interest rate-hiking cycles were measured by Fed tightening cycles. The four tightening cycles since 1994 were: February March 1995, June 1999-May 2000, June 2004-July 2006, December 2015 to December PAST PERFORMANCE IS NOT INDICATIVE OF FUTURE RESULTS. THE PERFORMANCE SHOWN ABOVE IS INDEX PERFORMANCE AND IS NOT REPRESENTATIVE OF ANY FUND S PERFORMANCE. INDICES ARE UNMANAGED AND NOT AVAILABLE FOR DIRECT INVESTMENT. PLEASE SEE BACK PAGE FOR INDEX DEFINITIONS. FOR ILLUSTRATIVE PURPOSES ONLY. 5

6 The fixed-income markets can be complicated, and your financial advisor can help you choose among the wide range of options that are appropriate for you based on the interest-rate environment, how much risk you re comfortable taking, and your investment goals. Investment Implications: Keep the following in mind as we make our way through a period of expected interest-rate increases: Though they tend to lower bond prices in the short term, interest-rate hikes have generally led to higher fixed-income returns down the road for investors who have stayed the course. Regardless of rate increases, fixed income should remain a consideration in investor portfolios to help act as a bulwark against equity volatility. High-yield bonds and bank-loan exposure may be viable portfolio options for the income-seeking investor during periods of rising rates. 6

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8 All investments are subject to risk, including the possible loss of principal. There is no guarantee the Fund will achieve its stated objective. The Fund s share price may fluctuate due to market risk and/or security selections that may underperform the market or relevant benchmarks. Fixed Income risks include credit, liquidity, call, duration, and interest-rate risk. As interest rates rise, bond prices generally fall; these risks are currently heightened because interest rates are at, or near, historical lows. High-yield ( junk ) bonds involve greater risk of price volatility, illiquidity, and default than higher-rated debt securities. Municipal securities may be adversely impacted by state/local, political, economic, or market conditions. Investors may be subject to the federal Alternative Minimum Tax as well as state and local income taxes. Capital gains, if any, are taxable. Diversification does ensure a profit or protect against a loss in a declining market. U.S. Treasuries are secured by the full faith and credit of the U.S. Government and offer a fixed rate of return. Bank loans can be difficult to value and highly illiquid; they are subject to credit risk and risks of bankruptcy and insolvency 1 The U.S. Aggregate Bond Index is composed of securities from the Government/Credit Bond Index, Mortgage-Backed Securities Index, Asset-Backed Securities Index, and Commercial Mortgage-Backed Securities Index. 2 The U.S. Treasury Index is an unmanaged index of prices of U.S. Treasury bonds with maturities of one to 30 years. 3 The US MBS Fixed Rate Index measures the performance of investment grade fixed-rate mortgagebacked pass-through securities of GNMA, FNMA, and FHLMC. 4 The U.S. Corporate Investment Grade Bond Index covers all publicly issued, fixed rate, nonconvertible, investment grade debt. 5 The U.S. 1-3 Year Government/Credit Bond Index is an unmanaged index comprised of the U.S. Government/Credit component of the U.S. Aggregate Index. 6 The Credit Suisse Leveraged Loan Index is designed to mirror the investible universe of the United States dollar-denominated leveraged loan market. 7 The U.S. Corporate High-Yield Bond Index is an unmanaged broad-based market-value-weighted index that tracks the total return performance of non-investment grade, fixed-rate, publicly placed, dollar denominated and nonconvertible debt registered with the Securities and Exchange Commission. 8 The S&P 500 Index is a market capitalization-weighted price index composed of 500 widely held common stocks. 9 The Municipal Bond Index is an unmanaged index of municipal bonds with maturities greater than two years. Investors should carefully consider the investment objectives, risks, charges, and expenses of Hartford Funds before investing. This and other information can be found in the prospectus and summary prospectus, which can be obtained by calling (retail) or (institutional). Investors should read them carefully before they invest. Mutual funds are distributed by Hartford Funds Distributors, LLC (HFD), Member FINRA. Hartford Funds Management Company, LLC (HFMC) is the mutual funds investment manager. WP361_ hartfordfunds.com hartfordfunds.com/linkedin