Investing in a rising rate environment - J.P. Morgan Asset Management

Investing in a rising rate environment

Contributor Alex Dryden

The next few years are likely to be tough for investors in fixed income, after a decade in which interest rate cuts and Federal Reserve (Fed) asset purchases helped bonds rally at an annualized 4%.1 With the U.S. economy motoring along, the slow pace of rate hikes may pick up; we anticipate at least one more this year and three to four in 2018. The Fed also said in March that shrinking its $4.5 trillion balance sheet would “likely be appropriate later this year.” These tightening measures would come just as the average duration of major bond indices is unusually high, meaning more sensitive to rising rates. (Exhibit 2) What can investors do?

The effects of tightening on the fixed income market

Investors are not accustomed to Fed balance sheet reduction. And markets are pricing in just two more 0.25% rate hikes by June 2019, suggesting they are not braced for a faster-moving Fed. In its June meeting the Fed outlined how balance sheet reduction operations will begin at a low level of $ 10 billion, with quarterly increases of $ 10 billion, giving investors time to adjust. We have fewer clues on the final balance sheet size the Fed seeks. Investors will look for clarity on these questions, to minimize market volatility.

Three potential actions fixed income investors can take

Diversify: Long-dated U.S. Treasury bonds tend to decline most sharply when rates rise; investors can seek safety by managing the duration of their portfolio’s securities. Investors can also diversify across fixed income sectors that may hold up well amid rising rates: U.S. high yield, for example, has historically declined on average 4% when rates rise 1%, but large coupons provide an offset. Another option is to diversify geographically, as monetary policy divergence between the U.S. and other countries seems likely continue for the time being. Many international fixed income benchmark bond indices have a low, or negative, correlation with U.S. rate moves. (Exhibit 4) And the cost of hedging international currency risk is relatively low today.

Bonds have important role to play

Historically, fixed income has provided welcome stability to portfolios, smoothing investors’ path in challenging times. During the last 20 years, in months when the S&P 500 declined, equities fell 3.6% on average, while the benchmark U.S. bond index rose an average 0.5%. Fixed income can also act as an insurance policy if economic growth falters and a recession occurs sooner than expected. To diversify portfolios and contain volatility, fixed income will continue to play an important role.

1 Over the last decade, the Bloomberg Barclays U.S. Aggregate Bond Index has returned 4% on an annualized basis.

Duration for the benchmark index has risen from 3.7 years in December 2008 to six years in 2017
Exhibit 2: Modified duration of Bloomberg Barclays U.S. Aggregate Bond Index

Source: Bloomberg Barclays, FactSet, J.P. Morgan Asset Management. Data as of June 15, 2017.

Diversifying internationally can lower correlation to movements in U.S. rates
Exhibit 4: Correlation of Sectors to U.S. 10-year Treasury

Source: Bloomberg Barclays, FactSet, J.P. Morgan Asset Management. EMD sectors are represented by the J.P. Morgan EMBIG Diversified Index ($), the J.P. Morgan GBI EM Global Diversified Index (LCL) and the J.P. Morgan CEMBI Broad Diversified Index (Corp). European Corporates are represented by the Barclays Euro Aggregate Corporate Index and the Barclays Pan-European High Yield index. Sector yields reflect yield to worst. Duration is modified duration. Correlations are based on 10 years of monthly returns for all sectors. Data as of June 15, 2017.

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Investing in a rising rate environment

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