Despite their recent rise, interest rates are currently near all-time lows, with the federal funds target rate at 0%-to-0.25% and the 10-year U.S. Treasury note yielding less than 3%. Rates will inevitably rise as the economic outlook improves and/or inflation expectations increase, leading first to the reduction and eventually to the end of expansionary monetary policy.
When interest rates rise, the market value of previously issued fixed coupon bond holdings will fall as investor demand shifts to new, higher-yielding bonds. But not all securities are created equal. Bonds with shorter maturities, floating interest rates and/or higher yields should experience less dramatic price declines.
During periods of rising interest rates and stable credit conditions, investors can improve the total return of their bond portfolios by shifting into shorter duration and higher-income-generating strategies.
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A study of past rising rate cycles and dynamic scenario analysis of potential future rate moves can provide a valuable perspective to an investor managing liquidity through a rising rate environment.The directionality of interest rates is a critical determinant of the performance of fixed income securities. As rates fall and rise in cycles, bond markets can turn from boom to bust, creating or destroying investment value in a sometimes unpredictable fashion. In periods of falling interest rates, previously issued fixed coupon securities will typically increase in market value. When rates are rising, those same securities will decrease in value.
For more than 30 years, U.S. interest rates have been in a period of secular decline. Since September 1981, when yields on the 10-year U.S. Treasury (UST) reached nearly 15.9%, interest rates have trended downward, hitting an all-time low in July 2012, when the 10-year UST yielded just under 1.38%. While rates have recently risen, the move has been relatively muted, and yields remain well below historical averages (EXHIBIT 1):
At some point this extraordinary stimulus will be retracted, inflationary pressures will rise, and expansionary monetary policy will end. This should lead to a rise in interest rates, with negative repercussions for existing holdings in most traditional fixed income investments. Fed rhetoric and recent market activity signal that a period of rising rates may be on the horizon.
This article examines the risks of rising rates. We explore how we arrived at the current market juncture and consider prior rising rate periods, using indexes as proxies to determine how various fixed income strategies performed. We demonstrate how to use dynamic scenario analysis to better understand the possible return implications of interest rate and credit spread movements. Finally, we outline strategies and solutions to best insulate a short-term fixed income portfolio in a rising rate environment.
Extraordinary response to an extraordinary crisis
The current era of low interest rates is best explained by the unprecedented actions that the Fed and other central banks took in response to the global financial crisis. The Fed initially employed traditional monetary policy tools, lowering the federal funds target rate from 5.25% in September 2007 to a 0%-to-0.25% range in December 2008 (where it has since remained). In November 2008, amid near-frozen credit markets, overnight rates close to zero and the U.S. economy mired in the worst recession since the 1930s, the Fed embarked on a program of quantitative easing (QE).
"As of July 2013, the Fed had more than $3 trillion on its balance sheet, compared with less than $1 trillion before the financial crisis."
Quantitative easing sought to contain the financial crisis, limit its impact on the broader economy and aid the prolonged recovery by lowering longer-term interest rates to encourage investment and consumption. In three rounds of QE over more than four years, the central bank extended the size and average maturity of its balance sheet assets through the purchase of agency debentures, mortgage-backed securities (MBS) and Treasuries. As of July 2013, the Fed had more than $3 trillion on its balance sheet, compared with less than $1 trillion before the financial crisis. Meanwhile, the Fed’s Treasury holdings maturing in less than one year shrank to less than 1% of its Treasury portfolio, down from approximately 50% pre-crisis.
Long-term bond mutual funds experienced more than $60 billion in net outflows during the month.
In May 2013, Fed chairman Ben Bernanke indicated that the Fed could begin reducing its monthly asset purchases later this year if improvements in economic growth seem sustainable. In June, after the Fed noted that asset purchases may end altogether in mid-2014, investors aggressively sold off both risk assets and Treasuries. 1 Prior to June 2013, the last month of net outflows was August 2011. Between the end of August 2011 and June 2013, investors poured in about $450 billion in net cumulative long-term bond mutual fund assets. As flows reversed, fixed income asset sales in June pushed yields of the 10-year UST to over 2.60%, from just 1.63% at the beginning of May. Credit spreads also widened over the month. 2 Yields have risen somewhat since June. As of mid-August, longer tenors had moved more sharply than shorter tenors, year-to-date (EXHIBIT 2).
As the central bank has signaled, reductions in asset purchases will be the first step toward the normalization of monetary policy. (The Fed has repeatedly emphasized that this decision will be “data dependent.”) Ending the QE program would be its inevitable second step. If economic conditions warrant, the Fed’s further moves would include modifying forward guidance on raising the fed funds target rate and, eventually, increasing that rate.
Fed communications suggest that the current target rate level will likely remain appropriate for a considerable period of time. However, as investors anticipate diminished monetary accommodation and eventual tightening by the Fed, demand for fixed income securities will fall, causing prices to drop and market interest rates to rise.