Bonds March 30, 2018

    Amid broad global economic growth and a strong labor market, the Federal Reserve raised interest rates a quarter percentage point in March 2018 in its sixth rate hike since it began raising rates in December 2015. The Fed’s series of rate hikes in the current tightening cycle have gradually increased the federal funds rate from essentially zero to a range of 1.50% – 1.75%. The prospect of higher rates going forward has caused some investors to question the fixed income allocations in their portfolios. After all, rising interest rates mean lower bond prices, right? While this inverse relationship is true in the broadest sense, it's also an oversimplification.

    First, it's important to remember that bonds can play an important role in a well-diversified portfolio regardless of the market environment. In addition to providing income, bonds generally have lower volatility and don't move in lockstep with asset classes such as stocks. That means bonds can help provide diversification and potential stability when financial markets become volatile, such as during the turbulence that resulted in a stock market decline of more than 10% at the beginning of 2018. Furthermore, returns from bonds and bond exchange-traded funds (ETFs) come from two sources: interest payments and changes in price. So higher rates can boost interest payments and help buffer negative price returns. Over time, returns on bonds tend to be driven more by income than by price changes.

    Second, the bond market is not one homogenous entity. There is a wide variety of bonds, including Treasuries, investment-grade corporate bonds, municipal bonds, high-yield bonds, securitized bonds, international bonds and many others. (See our white paper "Guide to Asset Classes & ETFs" for a description of each of these types of bonds.) Each of these bond market segments has different characteristics. And within various market segments, bonds can have a range of maturities, from short- to long-term, and a range of credit quality, from the highest rated with little default risk to the lowest rated with much higher default risk. These different characteristics lead to differences in how various bond market segments respond to changes in interest rates and other economic conditions.

    Diversified bond exposure with relatively moderate interest rate risk

    Schwab Intelligent Portfolios® includes 11 different asset classes within fixed income, with the mix in any single portfolio based on an investor's objective, time-horizon and risk profile. This is intended to diversify portfolios across a range of different U.S. and international bond market segments with different characteristics.

    To help keep sensitivity to rising interest rates in check, fixed income ETFs selected for inclusion in Schwab Intelligent Portfolios tend to have intermediate-term maturities and moderate interest rate risk, or sensitivity to rising and falling interest rates. All else being equal, shorter-term bonds are generally less interest rate sensitive than longer-term bonds.

    Higher short-term rates don't necessarily mean higher long-term rates

    In terms of overall interest rate risk, the Fed reiterated in its statement that it expects "gradual increases" in interest rates going forward, indicating that it still projects a slower pace of rate hikes than in previous tightening cycles. The Fed expects to raise the federal funds target rate three times in 2018 to about 2.1% and three times in 2019 to about 2.7%, with a long-term projection of 2.8%.

    Additionally, it's important to remember that the Fed controls short-term rates while longer-term rates are determined by market participants and influenced by a range of economic factors. Just because the Fed is raising short-term rates, that doesn't necessarily mean that long-term rates will rise commensurately. For example, during the last tightening cycle from June 2004 to June 2006, the fed funds rate increased a total of 4.25 percentage points while the yield on the 10-year Treasury rose just 0.53 percentage points. Over the current cycle, the Fed has raised rates 1.50 percentage points since December 2015, while the yield on the 10-year Treasury has risen 0.80 percentage points to 2.84% as of March 20, 2018, versus 2.24% at the beginning of 2016.

    How bonds have performed when interest rates have risen in the past

    Figure 1 shows how various types of bonds have performed when the Fed was raising interest rates during previous tightening cycles. When the Fed has taken a slower pace to increasing rates, such as during the current cycle and 2004– 2006, bond returns remained positive and quite strong in some asset classes. By contrast, when the Fed has raised rates more rapidly and sharply, such as 1999–2000 and 1994–1995, bond returns were weaker. Notably, however, even during these faster cycles, some types of bonds have produced strong returns over time, such as Treasury-inflation protected securities (TIPS) in the 1999–2000 cycle and international bonds in the 1994–1995 period.

    Every market cycle is unique, and interest rates could rise more rapidly than expected going forward, potentially hurting bonds in the short term. Various bond asset classes have come under some pressure in 2018 as longer-term rates have risen amid concerns about potential inflation. But it's important not to overreact to short-term volatility. The Fed's continued forecast for a slow pace toward rate hikes in 2018 and future years suggests that the current period might continue to track more closely to 2004–2006 than to the earlier periods.

    Figure 1: Bonds have performed better during periods of gradual rate hikes
    Return per year (%)
    Rising rate cycle Months Fed funds rate Treasuries Investment-grade corporate High-yield TIPS Securitized International
    12/2015–present* 27 0.0–? 0.7 4.3 9.9 2.8 1.2 6.6
    6/2004–6/2006 25 1.25–5.25 2.7 2.9 8.6 3.6 3.4 4.3
    6/1999–5/2000 12 5.0–6.5 3.4 0.0 -3.1 6.0 2.4 -6.2
    2/1994–2/1995 13 3.25–6.0 -0.8 -0.9 -1.2 NA NA 8.8

    Source: Morningstar Direct. *As of 3/20/2018. Returns are annualized for periods longer than one year. Indexes used are Treasuries, Bloomberg Barclays Aggregate Treasury Index; investment-grade corporate bonds, Bloomberg Barclays U.S. Corporate Investment Grade Index; high-yield bonds, Bloomberg Barclays Very Liquid High Yield Index; Treasury Inflation Protected Securities, Bloomberg Barclays U.S. Treasury TIPS Index; securitized bonds, Bloomberg Barclays U.S. Securitized Index; international bonds, Bloomberg Barclays Global Aggregate ex-USD Index.

    Fixed income investments have a purpose within a well-diversified portfolio

    For most investors, it's not a matter of going all-in with bonds or folding completely. It's a matter of selecting what types of bonds, as well as their maturity and credit quality, to include in a well-diversified portfolio.

    Remember the reasons why bonds are in your portfolio: to help provide diversification and potential income. While financial markets might experience some volatility as the Fed gradually raises short-term interest rates, bonds can play an important role within a well-diversified portfolio.

    Navigating the complexities of the bond market can be tricky, particularly in a rising rate environment. With Schwab Intelligent Portfolios, you can get a diversified mix of exchange-traded funds (ETFs) within a managed portfolio that includes up to 20 asset classes based on your individual risk profile.

    By David Koenig, CFA, FRM, Chief Investment Strategist, Charles Schwab & Co., Inc.

    The Barclays US Corporate High Yield Bond Index measures the U.S dollar-denominated, high yield, fixed-rate corporate bond market. Securities are classified as high yield if the middle rating of Moody's, Fitch and S&P is Ba1/BB+/BB+ or below.

    The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

    Investing involves risk, including possible loss of principal.

    Diversification strategies do not ensure a profit and do not protect against losses in declining markets.

    Some specialized exchange-traded funds can be subject to additional market risks. Investment returns will fluctuate and are subject to market volatility, so that an investor's shares, when redeemed or sold, may be worth more or less than their original cost.

    Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed income investments are subject to various other risks including changes in credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications and other factors.

    The lower-rated securities in which a high-yield fund invests are subject to greater credit risk, default risk and liquidity risk.

    While ETFs offer intraday trading, they may be more susceptible to liquidity challenges during market hours compared to mutual funds that are priced after the market close.


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