Are Rising Interest Rates Affecting the Bond Market | William Blair
The state of the bond market has undergone significant changes when comparing the current scenario to that of a year ago.
Returns have increased substantially, which is a result of the Federal Reserve's decisive increase in interest rates in order to combat inflation in the past year. Consequently, bonds are able to fulfill their conventional function of generating income for individuals who purchase and keep fixed-income securities until maturity.
Ever since the Federal Reserve started increasing its desired interest rate last year, rates have surged and now stand at a range of 5% to 5.25%, a stark contrast from the near-zero levels witnessed back in March 2022. This upswing in rates marks the swiftest rate hike in forty years.
The increase in interest rates has had and still has an effect on how investors are assessing the balance between risk and reward. In the past year, the Federal Reserve's forceful boost put pressure on the worth of bond investments, as bond prices and yields move in opposite directions.
“Throughout history, bonds have consistently offered a degree of stability in investors’ overall portfolios, particularly when it comes to high-quality bonds,” explains Tyler Glover, the director of William Blair Consulting Services. “Despite the challenges faced by bond investors last year, we have now reached a stage where investors are being adequately rewarded with returns in the form of yields.”
Although returns have increased across different time periods, the Federal Reserve's decision has resulted in an unusual situation where short-term securities have higher interest rates compared to longer-term ones. In a more logical setting, the market would offer higher returns to investors who choose to hold onto long-term bonds, recognizing the increased risks associated with longer investment periods.
Long-Term Versus Short-Term Bonds
According to Clancy Burson, a fixed-income trader at William Blair, the greater returns in the early part of the curve are certainly garnering much attention from investors. Additionally, as long-term interest rates are historically elevated, investors are currently assessing the advantages and disadvantages of keeping longer-term bonds compared to shorter-term ones.
For example, back in June, T-bills with a maturity of six months were generating returns of 5% to 5.5%, while 5- and 10-year Treasuries were yielding around 4%. However, after six months, investors who have T-bills will have to deal with the possibility of reinvestment risk.
"Considering the present strategy of the Federal Reserve, there is a chance of experiencing a period of elevated short-term interest rates lasting six to 12 months or even longer. However, it is important to keep in mind that reinvesting will be necessary. Therefore, if we shift our focus towards the future, specifically two or three years ahead, it may be prudent to consider investing in a 5- or 10-year Treasury bond with a 4% yield as it could potentially offer superior returns."
The key factor is evaluating the exposure to changes in interest rates, according to Burson. This involves examining the correlation between a bond's price and yield, as well as its duration.
"At present, in terms of allocating assets, we are confident in including longer-term investments and lengthening the time until maturity to secure favorable interest rates in the long run."
The local government bond market is experiencing comparable patterns.
According to Debra Schalk, a trader at William Blair specializing in fixed-income, there has been a significant influx of bonds entering the market in the past three months. This can be attributed to mutual fund managers selling short-term municipal bonds in order to fulfill security repayments, as well as the outflows and FDIC liquidations caused by recent bank defaults. As a result of this increased supply of bonds, yields on short-term bonds have remained higher. Although there has been a slight decrease in fund outflows recently, this has been counteracted by the large number of municipal bonds reaching maturity in June. Consequently, the demand for bonds is strong, but the yields on 1-year bonds have remained above 3% so far.
"Short-term municipal bonds offer an impressive return compared to past performance, and the risk involved is minimal," Schalk comments. "However, 10-year bonds that yield more than 2.5% can also be considered a good return based on historical data. While the short-term bonds have a tempting yield of over 3%, it is essential to take a long-term perspective and diversify the portfolio with bonds of different maturities. This strategy, known as laddering, allows for a consistent cash flow over time."
Which Is Better: Investment-Grade Or High-Yield Corporates?
Investors who are seeking to embrace a slight level of additional uncertainty are exploring the realm of corporate bonds. Within this market, some unexpected price dynamics are currently being observed.
Investors closely monitor the variance in returns between investment-grade corporate bonds that are rated A and BBB, and high-yield bonds commonly known as "junk" bonds, which possess lower credit ratings. Both consider the yield on Treasuries, which are usually considered the safest investments, along with the creditworthiness of the company issuing the bonds.
In the beginning of June, to give an instance, we observed a substantial number of well-performing A and BBB corporations generating a yield of more than 5%, experiencing a noteworthy increase parallel to the Treasury market," affirms Burson. "Thus, the difference in credit quality had not undergone significant alterations."
In contrast, high-yield bonds were producing a return of slightly above 6%, with a difference of approximately 1.25%. Ordinarily, investors would seek a premium of 2% to 3% compared to A or BBB corporates, considering the extra risk associated with holding lower-rated bonds.
"At the moment, high-yield bonds are not providing an additional benefit, whereas high-quality investment-grade corporate bonds are currently more appealing," Burson explains. "We will closely monitor any potential increase in the difference between these two types of bonds, and reassess the situation accordingly."
Experts point to the Federal Reserve's money-related strategy and economic circumstances as significant influencers of the bond market's trajectory moving ahead. During their June gathering, the Fed chose to maintain interest rates at their current level, which was the first occurrence in over a year. Nevertheless, they hinted in their economic forecasts that rates may increase by an additional half a percentage point by the year's end.
The general anticipation in the market is that inflation will likely reach a satisfactory point in the near future, potentially by early 2024. This development would lead to the Federal Reserve feeling content enough to halt its policy of increasing interest rates. Individuals who hold bonds may be in a favorable position due to this change in policy. Furthermore, bonds can play a crucial role in generating income and effectively managing risks during a possible economic downturn.
"Undoubtedly, these are factors to take note of and stay informed about," Glover states. "However, it's important to acknowledge that we have no power over Federal Reserve choices, the economy, or the market's response. The key lies not in trying to time the market, but in prioritizing a long-term plan that aligns with your investment objectives.
Continuing to communicate with your William Blair advisor should remain a priority. This conversation holds significant importance in such a situation.
The return and/or revenue shown in the past performance does not guarantee future results. This information is provided for informational purposes and should not be relied upon for accounting, legal, tax, or investment advice. We recommend consulting with a tax and/or legal advisor to discuss your specific circumstances. Investment advice and recommendations can only be given after carefully considering an investor's goals, guidelines, and limitations. The statements provided are based on sources we consider reliable, but we make no guarantees regarding their accuracy or completeness. The opinions expressed are our own unless otherwise stated and are subject to change without prior notice.
