All Fixed Income Sectors Are Not Created Equal
Will they or won’t they? Federal Reserve Chair Yellen testified before the Senate Banking Committee the central bank’s plans to keep interest rates low for some time, yet minutes from the Fed’s January meeting reveal internal debate about whether the timetable to raise short-term rates should be sooner rather than later. In our opinion, the continued uncertainty over the direction of rates means that investors should consider keeping duration in the short- to intermediate parts of the yield curve with an overweight to spread sectors.
Not all sectors within fixed income are created equal. Now is not the time to abandon bonds but to consider exposure to fixed income sectors more likely to weather interest rate volatility in this current low rate environment. While U.S. Treasuries are often considered credit risk-free (due to their U.S. government backing), they expose investors to more interest rate risk than other fixed income sectors. As a general rule, interest rates and bond prices move in opposite directions. When rates rise, bond prices fall (and, when rates fall, bond prices rise). However, the impact of a rate increase on total return can vary widely for different types of bonds.
Treasuries—along with other higher-quality, lower-yielding fixed income securities with less credit risk—are more likely to experience negative total returns as rates rise because the downward pressure on prices is not sufficiently offset by the income earned. In addition, lower yielding sectors typically have lower spreads (the difference between the yield of a fixed income sector and the yield of a comparable maturity Treasury), and therefore less room for tightening to offset a potential rate increase. This was clearly illustrated last year when the Fed’s “taper talk” drove the 10-year Treasury yield over 3.00% and resulted in declines in the prices of those securities and other high-quality bonds.
We believe that a focus on short- to intermediate-term debt within the higher yielding sectors of the fixed income markets presents the best opportunity to generate income and weather the impact of falling bond prices when rates rise. While this means greater exposure to credit risk, it’s a risk worth taking as we continue to be in a benign credit environment.
10-Year U.S. Treasury Rates, 9/3/13-3/6/14