Investing in a rising rate environmentContributor 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
Please be aware that this material is for information purposes only. Any forecasts, figures, opinions, statements of financial market trends or investment techniques and strategies expressed are, unless otherwise stated, J.P. Morgan Asset Management’s own at the date of this document. They are considered to be reliable at the time of writing, may not necessarily be all-inclusive and are not guaranteed as to accuracy. They may be subject to change without reference or notification to you. JPMorgan Asset Management Marketing Limited accepts no legal responsibility or liability for any matter or opinion expressed in this material.
The value of investments and the income from them can fall as well as rise and investors may not get back the full amount invested. Past performance is not a guide to the future.