Within financial circles, the prevailing view about fixed income is that the bond market’s glory days are numbered. According to conventional wisdom, a rapidly expanding economy brings with it the dreaded kryptonite of inflation to the bond market, which reduces purchasing power and thus causes fixed-income values to spiral downward, resulting in negative returns to bond investors. While this is a reasonable theory, the outcome is far from certain. In our view, there remains a justifiable role for fixed income in a portfolio, even in a higher rate environment.
Role of Bonds
Fixed-income securities provide the dual benefits of income as well as price stability. It’s obvious that the regular coupon income from bonds creates a steady positive income flow. What’s less obvious is that bond values act as a hedge in the event of economic uncertainty and geopolitical risks and fears—problems that persist today.
Even in a higher-rate environment, a fixed-income portfolio doesn’t have to face the wrath of sharply lower values. First and foremost, bonds have a terminal maturity date (unlike many other asset classes). So even if the value of bonds falls as a result of higher rates, they always pay back principal and interest over the life of the issue and at maturity, except in the case of default.
It’s also important to note that not all bonds are created equal. For example, short-term bonds are less volatile than long-term bonds, and higher-quality issuers are more stable than lower-quality issuers. Additionally, some complementary, non-core fixed-income strategies (see table) should perform better in a rising U.S. rate environment and benefit an otherwise broad, well-diversified bond portfolio. This being said, it follows that a strategy of high-quality, short- to intermediate-term bonds are well protected in the event of higher rates. In fact, if positioned optimally along the maturity spectrum, a portfolio may benefit from reinvesting maturing principal and income payments at higher, more attractive rates. Lastly, if additional non-core assets are utilized tactically, these higher rates also may benefit the overall portfolio.
Outlook for Rates From Bond Market Perspective
While some observers consider a spike in interest rates inevitable, we believe it’s still too early in the economic recovery to expect that outcome. The overall economy certainly has improved since the onset of the financial crisis, but it can hardly be described as robust. Three commonly followed economic barometers (see table) suggest that we remain far removed from what would be considered a rapidly expanding economy that would trigger changes to the country’s broader monetary policies.
*Bloomberg Composite Forecast 2014 Source: Bloomberg
It’s important to note that the modest growth experienced since 2008 occurred only after massive and unprecedented stimulative policies implemented by the Federal Reserve over several years. Indeed, the Fed overnight rate has been reduced to zero, a number of asset protection measures have been instituted to increase confidence, and it continues to actively purchase long-term bonds to keep rates low. The Fed also has indicated it could take further steps to keep a low-rate environment until signs of a robust economy are clear. Our view is that despite positive signs, the economy still is reliant on these policies and not yet self-sustaining.
Continued economic headwinds have the potential to threaten progress as well. Fallout from the never-ending European debt crisis, a possible China asset bubble, and rising international tensions (from North Korea, the Middle East and elsewhere) all pose potential hurdles for the U.S. economy that would keep rates in check.
With the economic recovery still a work in progress, we believe fixed income should remain a vital part of a client portfolio. There continue to be diversification benefits from having bonds within a riskier overall portfolio. Given the likelihood the Federal Reserve would provide guidance regarding future policy changes, we also feel that any price risk to portfolios would be minimized. Importantly, the fundamentals of the U.S. economy don’t justify the notion that inflation will occur in the near future and pose a threat to a well-diversified, short- to intermediate-term portfolio. When rates are likely to rise, a properly positioned portfolio can benefit through broad diversification and an active maturity allocation.
The views of the authors of these articles do not necessarily represent the views of First Republic Bank. First Republic Private Wealth Management encompasses First Republic Investment Management ("FRIM"), the Luminous Capital division of First Republic Investment Management, First Republic Trust Company ("FRTC"), First Republic Trust Company of Delaware LLC and First Republic Securities Company, LLC ("FRSC"), Member FINRA/SIPC. FRIM, FRSC and FRTC of Delaware LLC are subsidiaries of First Republic Bank. FRTC is a separate division of First Republic Bank.
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