Following a 30-plus-year bull market in the fixed income or bond market, the path forward is much more uncertain. While investors await the next move for fixed income, unless bond prices move higher (and, by definition, bond yields move lower), historically low interest rates indicate that bonds will offer lower total returns than most bond investors have experienced during recent periods. Fears that the U.S. Federal Reserve would soon begin to rein in its bond-buying program have hurt fixed income in general. As a reminder, bond yields move in the opposite direction of prices, so when bond yields increase, by definition their prices concurrently fall. The 10-year Treasury yield, a proxy for key lending rates like mortgages and an oft-cited gauge of bond market movements, rose from 1.64 percent on May 1 to 2.16 percent on June 1, which in percentage terms was the largest month-over- month increase in yield history. Through late August, the 10-year Treasury continued its rise, hovering at levels not seen since in over two years. Many yield-sensitive asset classes and sectors have had sluggish performance in sympathy with higher interest rates, including corporate bonds, municipal bonds, public real estate, and some yield- producing sectors in the stock market. As investors have reached for yield across a variety of asset classes including those just mentioned, market observers remain focused on Federal Reserve guidance regarding future accommodation, which as of press time remained unclear. Where Will Interest Rates Go From Here? Looking at Figure Two, one can see that since the summer of 2011, 10-year Treasury yields have been firmly below 3 percent. This is due to global central banks’ active suppression of interest rates through buying fixed income securities in the open market in an attempt to encourage lending and spark economic activity. However, the U.S. Federal Reserve has recently hinted that those open market purchases could begin to slow, leaving investors to question who will replace the Fed and buy bonds. This speculation led to the second quarter’s weak bond market returns. Per Figure Two, it appears we are approaching interest rate levels that are strategic research report WHAT’S NEXT FOR THE BOND MARKET? 0% -1% -2% -3% -4% -5% -6% -7% 1% 2% BarCap Aggregate Bond Index BarCap Municipal Bond Index BarCap U.S. Corporate High Yield Index S&P U.S. Preferred Stock Index Alerian MLP Index Dow Jones U.S. Real Estate Index BarCap U.S. Treasury: U.S. Treasury TIPS Index -2.3% -3.0% -1.4% -7.0% -3.2% 2.0% -3.3% Figure One: Yield-Oriented Assets Q2 2013 Performance Source: Bloomberg, Zephyr Eric J. Freedman CAPTRUST Chief Investment Officer continued inside
Eric J. Freedman CAPTRUST Chief Investment Officer
continued inside
WWW.CAPTRUSTADVISORS.COM
halfway between the lows seen in the
summer of 2012 and the higher levels seen
before the summer of 2011. From here,
rates can do one of three things: move
lower, remain flat, or move higher.
Let’s Explore the Case for
Each Scenario
• Ratesmovelower: This scenario
could happen for several reasons, most
likely driven by economic weakness
that causes the Fed and other central
banks to continue their bond purchases.
Sticky unemployment, a slowing China,
continued European market malaise, and
weaker equity and riskier asset classes
could all cause this development. While
this may seem implausible given where
interest rates sit right now, we have seen
them at even lower levels; the 10-year
Treasury touched below 1.4 percent in
July 2012, a full percentage point lower
than today.
•Ratesremainflat: A goldilocks
economy, growing neither too fast nor
too slow, where inflation remains tame
(the Bureau of Labor Statistics notes
that month-over-month change in the
Consumer Price Index has fallen over
the past two months) and employment
and wage growth remain tepid could
continued from cover
"Rising yields do not always translate into bond investor losses. Two key variables will likely determine how acutely rising rates may impact bond investors: the magnitude of the rate increase and the speed at which rates increase."
cause interest rates to hover at or near
current levels.1
•Ratesmovehigher:An economy
showing resilience, the Fed backing off its
recent bond purchase trend (or anticipation
thereof), inflationary pressures, or asset
allocation movement toward riskier asset
classes or foreign bonds could all drive
interest rates higher. As described earlier,
rising prevailing interest rates tend to hurt
bondholders.
Our base case scenario is for rates to rise,
but to do so at a gradual pace over the next
18 to 24 months subject to numerous fits
and starts depending on the economy’s
health and central bank involvement. If we
are wrong, we suspect it will be because a
move higher happens faster than we expect,
perhaps accelerated by investor overreaction
to market news.
The Need to Gauge Speed
While higher interest rates could hurt bond
investors, as Figure Three shows, rising
yields do not always translate into bond
investor losses. Two key variables will likely
determine how acutely rising rates may
impact bond investors: the magnitude of the
rate increase and the speed at which rates
increase. The higher rates move and the
shorter the time period, the more painful
the experience.
For example, from December 2008
through March 2010, the 10-year Treasury
yield rose by almost 1.5 percentage points
while the BarCap Agg returned more than
8.7 percent. This was the result of a modest
rate increase (as a percent of the starting
yield) and a timeframe long enough for
coupon payments to outweigh the price
decline. Also, because the BarCap Agg is
a diversified index that includes corporate
and mortgage bonds, some decoupling from
government bonds may have occurred.
By contrast, in May, a mere 0.5
percentage-point increase in 10-year
Treasury yields set the bond market back
as coupons failed to offset falling bond
prices over such a truncated period. In
addition, since interest rates are very low,
the starting yield did not provide much of a
cushion against higher rates.
What Can Bond Investors Expect
Moving Forward?
CAPTRUST research suggests that current
interest rates often portend future returns. As
Figure Four displays, the prevailing interest
rate as measured by the 10-year Treasury
provides a reasonable approximation of five-
year forward annualized fixed income returns
as measured by the BarCap Agg (note that
forward returns starting in 2009 are for less
than five years and are as of June 7, 2013).
3
continued on back
4.0%
3.5%
3.0%
2.5%
2.0%
1.5%
1.0%
0.5%
0%2010 2011 2012 2013
Dates Number of Months
Increase in the 10-year Treasury Yield
BarCap Agg Total Return
June 1, 1979 – February 28, 1980 9 3.81% -10.73%
June 1, 1980 – August 31, 1981 15 5.63% -5.81%
May 1, 1983 – May 31, 1984 13 3.42% -0.85%
January 1, 1987 – September 30, 1987 9 2.51% -2.88%
October 1, 1993 – October 31, 1994 13 2.48% -3.07%
January 1, 1996 – May 31, 1996 5 1.20% -2.53%
October 1, 1998 – December 31, 1999 15 1.91% -0.40%
March 1, 2004 – April 30, 2006 26 1.22% 1.83%
December 1, 2008–March 31, 2010 16 1.41% 8.76%
May 1, 2013 – May 31, 2013 1 0.52% -1.78%
So, you would interpret the chart this way:
in 1997, the 10-year Treasury started the
year yielding 6.43 percent. During the period
encompassing 1997–2002, the BarCap Agg
delivered a 7.42 percent annualized return.
Over time, the correlation between the
10-year Treasury’s starting yield and five-year
forward return has been over 0.9, a strong,
positive relationship. Correlation cannot be
higher than 1.0, and a correlation of 0.6 to
0.7 is considered high. Therefore, given the
10-year Treasury’s current low level, if the
relationship described holds, investors should
expect bond portfolios to deliver lower
nominal (non-inflation-adjusted) returns than
in prior periods.
Investment Manager Perspective
We polled a diverse set of bond portfolio
managers for their perspectives on the
bond market since the Federal Reserve’s
communication, and while their views are
subject to change, their perspectives are
as follows:
• TCWMetWest’sSteveKane,who
comanages the $25 billion MetWest Total
Return Fund, believes there is a 100 percent
probability that the Fed will maintain its zero
interest rate policy through 2013 — and a 95
percent probability through 2014.
• JerryLanzotti,whocomanagestheLord
Abbett Total Return Fund, thinks the Fed
is serious about tapering its bond purchase
program and that interest rate volatility will
persist along with consequent volatility in
other asset classes.
• ManagersatFidelity’s$13billionTotal
Bond Fund are most focused on the Fed’s
new data-driven approach. They believe,
if the Fed tapers on the aggressive end of
expectations, the worst case scenario for
10-year yields is a climb to 4 percent from
their current mid-2-percent range. Given
low core inflation and growth expectations,
they expect a much slower climb in rates
going forward.
Figure Four: 10-Year U.S. Treasury Yield vs. Barclays U.S. Aggregate Index, 1977–2012
Figure Three: Periods Where 10-Year Treasury Yields Increased More Than 0.3% and Corresponding Barclays Capital Aggregate Index Returns, 1979–2013
Figure Two: U.S. 10-Year Treasury Yields (January 2010–June 2013)
Source: Federal Reserve Bank of St. Louis (http://research.stlouisfed.org/fred2), Bloomberg
The opinions expressed in this report are subject to change without notice. This material
has been prepared or is distributed solely for informational purposes and is not a solicitation
or an offer to buy any security or instrument or to participate in any trading strategy.
The information and statistics in this report are from sources believed to be reliable but
are not warranted by CAPTRUST Financial Advisors to be accurate or complete.
CAPTRUST Financial Advisors does not render legal, tax, or accounting advice.
ABOUT CAPTRUST DeS MOIneS
CAPTRUST’s Des Moines office was created through the acquisition of the institutional retirement practice of Holmes Murphy & Associates in December 2010. The office is comprised of a specialty team of institutional retirement advisors with over 60 years of combined industry experience. Our institutional advisors are experts in defined contribution plans—such as 401(k), 403(b), and profit sharing plans—defined benefit plans, and nonqualified deferred compensation plans. Our core institutional services include fiduciary and investment management, participant education and advice, provider due diligence, and vendor
management. All services are provided with clear, unbiased advice by our experienced fiduciary partners.
The Des Moines team also offers private wealth services for executives and senior leaders of our institutional clients and affluent investors. With a focus on comprehensive financial planning, we embrace a holistic approach to addressing our clients’ wealth management needs. Leveraging our institutional-quality investment research, our services are designed to help you confidently grow and protect your financial assets.
WEST DES MOINES, IA 4401 Westown Pkwy Suite 220 West Des Moines, IA 50266 Phone: 515.657.4100
HEADQUARTERS 4208 Six Forks Road Suite 1700 Raleigh, NC 27609 800.216.0645 toll free 919.870.8891 fax
