Interest rates: How we got here and where we re going Prepared July 5, 2013 Summary Investors are understandably concerned about the state of the bond market today given that interest rates began moving sharply higher in May. In this paper, we provide information to help guide you through what may be a challenging period for fixed income investors. You ll gain a better understanding of: The combination of factors that contributed to the historically low interest rate environment today How rising rates can negatively impact bond investors The unique challenges for investors created by today s environment Factors that could drive rates significantly higher and why that may not occur What to expect in the bond market in the coming months Ways to position your portfolio to help weather today s unique environment Why interest rates reached historic lows Although interest rates have risen noticeably in May, June and July, yields on U.S. Treasury bonds remain historically low. Yields on other types of debt securities (corporate bonds, mortgage-backed securities, municipal bonds) have, for the most part, followed a similar pattern. The only other period in history where rates on Treasury bonds were driven this low was at the end of World War II. At that time, with much of the world in ruins as a result of damage caused by the war, the United States was favored as a safe haven for investment dollars, and bond yields reached similarly low levels. 10-Year U.S.Treasury Month-end yields since 1940 16% 14% 12% 1 8% 6% 4% 2% Situation Analysis Interest rates remain near historical lows 1940 1950 1960 1970 1980 1990 2000 2010 Jul 2013 Source: Global Financial Data, FactSet Likewise, money has flooded into U.S. Treasuries in record amounts over the last decade, but from varying constituencies. In our view, today s low-rate environment can be attributed to four key factors: 1. Sub-par economic growth: Since the recession ended in 2009, the economy has managed only a modest recovery. During periods of slower economic growth, investors tend to favor fixed income assets over risk-based assets. 2. Extraordinary monetary stimulus: The Federal Reserve (the Fed) has taken unprecedented steps to try to stimulate economic growth. Interest rates have been lowered to near zero percent on short-term instruments. The Fed also pursued several bondbuying programs, known as quantitative easing (QE), as a way to help spur investment and spending. 3. Global flight to quality: U.S. Treasury bonds have been highly sought after by investors worldwide. Many are attracted to the credit quality and liquidity of Treasury bonds at a time when other regions of the world are facing their own fiscal and economic struggles.
Page 2 $ in billions $18000 $16000 $14000 $12000 $10000 $8000 $6000 $4000 $2000 $0 4. Currency trends: Some countries are actively selling their currency against the dollar as a way to help boost their export activity. As a result, they often invest the dollars they ve bought into U.S. Treasuries, helping to increase the demand for government bonds and keeping yields down. How much has demand risen for U.S. Treasury securities? Since 2009: Domestic investors increased purchases by 110 percent The U.S. Government raised holdings by 165 percent The Fed boosted its ownership of Treasuries by 250 percent Foreign ownership of Treasury bonds rose by an astounding 315 percent As a result, the Treasury market, valued at $5.6 trillion in 1998, grew to more than $16 trillion by 2012. Growth of the Treasury market 1998 2012 Federal Reserve Domestic Investors U.S. Government Accounts Foreign Investors Source: Federal Reserve The concern today is that such broad-based demand for U.S. Treasuries can t be sustained. If that occurs, interest rates will rise and bond values will decline, as the principal value of bonds moves inversely to interest rates. What happens when rates rise? While a rising interest rate environment creates challenges for the bond market, not all segments of the market are affected in the same way. However, rising rates clearly have a negative impact on bond values. % price decline A modest 50 basis point (0.50 percent) shift in the yield curve can cause the market value of fixed income securities to drop. If the shift goes out to 100 basis points (1 percent), the price declines tend to be more dramatic for holders of U.S. Treasury and agency mortgage-backed securities. A 200 basis point shift in rates (2 percent) can create a significant impact across the full spectrum of the domestic bond market. -1% -2% -3% -4% -5% -6% -7% -8% -9% -1 Emerging Markets Foreign Developed Sovereign Impact of rising rates High Yield 50 basis point increase IntermediateTreasury Inflation- Protected Securities (TIPS) Intermediate Municipal Bond 100 basis point increase Intermediate Investment Grade Treasuries Source: Analysis by U.S. Bank Asset Management Group The greatest price pressure during a rising rate environment tends to fall on agency mortgage-backed securities. As rates rise, fewer consumers choose to refinance their home mortgages. This means mortgages are paid off more slowly, extending the duration of these bonds. The impact of interest rate changes is more dramatic on the principal value of longer-duration bonds. Sectors such as high yield (junk) bonds are likely to weather a rising rate environment better than others. Rising interest rates are often the result of a stronger economy, and in that environment investors may be willing to take more risk. Therefore, demand for high yield bonds rises. A better economy may reduce the chances that issuers of high yield bonds will default, also helping to support bond values. In addition, the attraction of higher yields on junk bonds tends to buffer the potential for price declines. Bonds from overseas issuers may also offer opportunity in a rising rate environment. Generally, foreign bonds have a lower correlation to the U.S. domestic bond market, meaning global rates won t necessarily move upward in tandem. Mortgage-Backed Securities 200 basis point increase
Page 3 Additional risks in today s environment We ve seen significant interest rate increases in the past, but today s environment may present special challenges. Movements in a bond s value are only one aspect of its return. The coupon it generates, meaning the income it pays to investors, is another important component of the return. However, given that coupons today are starting from such a low level, it is clear that they may provide little protection against potential rate hikes. By comparison, in the late 1980s, coupons were sufficiently high to completely offset the impact of interest rate hikes on bond values. In the 1990s, coupons were large enough to offset two-thirds of the lost principal value of bonds. By the late 2000s, coupons had dropped sufficiently so that they overcame only one-third of the price decline. 35% 3 25% 2 Is coupon able to offset price declines? 21% 18% 15% 12% Return component 15% 1 5% 9% 6% 3% 10-year Treasury yield -5% -3% -1-15% -6% -9% 1978 1979 1980 1981 1983 1987 1988 1990 1994 1996 1999 2003 2004 2005 2006 2009 10-year yield Price return Coupon return Source: Federal Reserve Today, with yields at historic lows, coupons may provide almost no protection against a loss in bond values as rates rise. As a result, investors must be cognizant of the need to allocate fixed income assets in a manner designed to help limit the potential loss in bond principal. Will rates move significantly higher? The conventional wisdom is that a dramatic change in the interest rate environment is likely to occur if specific circumstances develop. Following is our assessment of three notable catalysts to significantly higher rates and how each scenario is likely to play out: 1. China decides to scale back its purchases of dollardenominated securities: Approximately 30 percent of the outstanding debt of many of the largest global bond markets is owned by foreign buyers. However, the United States remains as one of the most attractive options for many foreign buyers given its strength, size and liquidity. Although Japan also has the size, its growth, demography, credit quality and fiscal issues seem to make it a less appealing choice for foreign investors. One of China s reasons for making such large bond purchases is to help keep its currency devalued, thereby boosting its export business. Given the important role exports play in China s economy, it is not likely to change its desire to own U.S. government debt anytime soon.
Page 4 Debt outstanding (shown in trillions, USD) $18 $16 $14 $12 $10 $8 $6 $4 $2 Split China s limited options for investing in foreign bond markets AA Varied $0 United States Japan Euro-area % Foreign owners Sources: U.S. Treasury, Ministry of Finance Japan, UK Debt Management Office, Bank of Canada, Australian Office of Financial Management, Swiss Federal Statistical Office; Data: 2012 2. Inflation rises at a faster pace: Inflation is also a potential catalyst to driving rates higher. Two of the larger components of the Consumer Price Index (CPI) home prices and employment cost are leading indicators of inflation. We have completed an analysis to reflect this dynamic by advancing home prices by six quarters and advancing employment costs by four quarters. In our view, the results indicate that inflation is not likely to be a factor in 2013 as the trends in both indicators seem to be signaling that we will be well into the latter half of 2014 before the impact of housing and wage growth could push inflation higher. This leads us to the conclusion that inflation will not be a near-term driver of an interest rate rise. Employment Cost Split United Kingdom Inflation an issue? AAA AAA AAA Canada Australia Switzerland 3. The Federal Reserve rapidly reduces or discontinues its quantitative easing policies: The Fed may decide on such a move if the economy shows signs of faster growth. We believe that any Fed action in this regard may result in a different outcome depending on the timeline the Fed follows to execute the process. In our view, the Fed is not likely to want to potentially impede stronger economic growth by withdrawing monetary stimulus too quickly. Still, we may see some reduction in the pace of Fed purchases by the end of 2013. The outlook In the second half of 2013, we fully expect global demand for U.S. Treasuries to remain strong. This is likely given that other major developed economies have their own issues. Europe continues to deal with a recession and ongoing debt problems and Japan s limited growth rate, demographic challenges, credit quality and fiscal issues make it a less appealing option. The United States remains firmly entrenched as the preferred safe haven for global investors. In addition, many countries are likely to continue to devalue their own currencies in order to help maintain strong export business. That will require more purchases of U.S. bonds. What s more, the issuance of new bonds by the Treasury should begin to scale back as the government tries to reduce the trajectory of U.S. debt. The Federal Reserve has indicated it will keep shortterm rates on hold through 2015, assuming core inflation remains under control. We anticipate the U.S. economy will show more strength as the year progresses, reducing the need for the Fed to intervene as dramatically with its QE program. The yield curve is likely to be modestly steeper by the end of the year. Inflation Home Prices 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 Source: FactSet
Page 5 Contributed by: Our current guidance In our view, most clients need to consider including fixed income investments as part of a broadly diversified portfolio mix. Those long-term allocations should remain intact even with concerns about today s interest rate environment. We recommend several steps to help position your portfolio to effectively manage today s environment: Avoid adding positions in the most interest rate-sensitive sectors of the market, namely Treasury bonds and mortgage-backed securities. Focus on steeper segments of the yield curve where yields sufficiently compensate you for the added risk you incur. Seek higher coupons across all fixed income credit qualities and sectors included in your portfolio to provide some defense against potential losses in principal value. Combining all of these strategies may help you better weather a continued upward trend in interest rates. Jennifer L. Vail Head of Fixed Income Research U.S. Bank Wealth Management Roosevelt D. Bowman Senior Fixed Income Analyst U.S. Bank Wealth Management IMPORTANT DISCLOSURES This commentary was prepared on July 5, 2013 and the views are subject to change at any time based on market or other conditions. This information represents the opinion of U.S. Bank and is not intended to be a forecast of future events or guarantee of future results. It is not intended to provide specific advice or to be construed as an offering of securities or recommendation to invest. Not for use as a primary basis of investment decisions. Not to be construed to meet the needs of any particular investor. Not a representation or solicitation or an offer to sell/buy any security. Investors should consult with their investment professional for advice concerning their particular situation. The factual information provided has been obtained from sources believed to be reliable, but is not guaranteed as to accuracy or completeness. U.S. Bank is not responsible for and does not guarantee the products, services or performance of third party providers. Any organizations mentioned in this commentary are not affiliates or associated with U.S. Bank in any way. U.S. Bank and its representatives do not provide tax or legal advice. Clients should consult their tax and/or legal advisor for advice and information concerning their particular situation. Past performance is no guarantee of future results. Equity securities are subject to stock market fluctuations that occur in response to economic and business developments. International investing involves special risks, including foreign taxation, currency risks, risks associated with possible difference in financial standards and other risks associated with future political and economic developments. Investing in emerging markets may involve greater risks than investing in more developed countries. In addition, concentration of investments in a single region may result in greater volatility. Investing in fixed income securities are subject to various risks, including changes in interest rates, credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications, and other factors. Investment in debt securities typically decrease in value when interest rates rise. The risk is usually greater for longer term debt securities. Investments in lower rated and non rated securities present a greater risk of loss to principal and interest than higher rated securities. Investments in high yield bonds offer the potential for high current income and attractive total return, but involve certain risks. Changes in economic conditions or other circumstances may adversely affect a bond issuer s ability to make principal and interest payments. The municipal bond market is volatile and can be significantly affected by adverse tax, legislative or political changes and the financial condition of the issuers of municipal securities. Interest rate increases can cause the price of a bond to decrease. Income on municipal bonds is free from federal taxes, but may be subject to the federal alternative minimum tax (AMT), state and local taxes. Investments in mortgage-backed securities include additional risks that investors should be aware of such as credit risk, prepayment risk, possible illiquidity and default, as well as increased susceptibility to adverse economic developments. Treasury Inflation-Protected Securities (TIPS) offer a lower return compared to other similar investments and the principal value may increase or decrease with the rate of inflation. Gains in principal are taxable in that year, even though not paid out until maturity. There are special risks associated with an investment in commodities, including market price fluctuations, regulatory changes, interest rate changes, credit risk, economic changes, and the impact of adverse political or financial factors. Investments in real estate securities can be subject to fluctuations in the value of the underlying properties, the effect of economic conditions on real estate values, changes in interest rates, and risks related to renting properties (such as rental defaults). 2013 U.S. Bancorp (7/13) reserve.usbank.com