Worried About Rising Rates? Here’s Why You Shouldn’t Be

18 September 2017

3 min read

Matthew Sheridan, CFA| Lead Portfolio Manager—Income Strategies

Gershon M. Distenfeld, CFA | Director—Income Strategies

Should tighter monetary policy on both sides of the Atlantic worry bond investors? We don’t think so. Bonds have historically delivered positive returns when interest rates rise—particularly when they rise gradually.

Of course, we appreciate investors’ concerns. After the global financial crisis, central banks provided unprecedented life support for markets and the global economy by cutting interest rates to record lows and buying trillions of dollars’ worth of bonds. Ending such massive monetary stimulus won’t be easy.

But that doesn’t mean it has to be painful or disruptive, either. We expect central banks to withdraw this extraordinary support very slowly.

Interest rates are rising in the US, but the Federal Reserve is moving at a snail’s pace—it has hiked rates just four times in 18 months. The Fed will probably reduce its balance sheet slowly, too—likely by letting some of its bonds mature each month without reinvesting the proceeds. Fed Chair Janet Yellen predicted that the reduction, far from roiling markets, would be about as exciting as “watching paint dry.”

The European Central Bank, meanwhile, is nowhere near ready to raise interest rates. But with eurozone growth improving, it has signaled that it may soon begin reducing the amount of bonds it buys each month. Again, though, we expect that policymakers will be in no hurry to end purchases altogether.

Why You Should Want Rates to Rise

To get a sense of what might be in store for the bond market, it helps to recall the Fed’s last tightening cycle, where 17 quarter-percentage-point rate hikes were spread over a two-year period. Both the 10-year US Treasury Index and the US high-yield bond market produced positive annualized returns (Display).

US Rates: As Fed Hikes, What Should We Expect?

Performance During Last Fed Tightening Cycle

As of June 30, 2017
Current analysis and forecasts do not guarantee future results.
The time period shown above is as of the month-end prior to the official rate hike and through the month-end following the last increase in official rates.
An investor cannot invest directly in an index, and its performance does not reflect the performance of any AB portfolio. The unmanaged index does not reflect the fees and expenses associated with the active management of a portfolio. *Basis point (b.p.): A unit equal to 1/100th of 1%, used to denote the change in a financial instrument.
Source: Bloomberg Barclays and AB

How was this possible? Aren’t bonds highly sensitive to interest-rate movements? Yes, but as long as they don’t default, bonds also produce a steady stream of income. And when rates rise, investors can reinvest the proceeds of their maturing bonds in newer—and higher-yielding—bonds. This often outweighs any short-term losses from rising rates and increases total return.

In other words, investors who rely on their bond portfolios to provide income over a long time period should be rooting for higher rates.

A rapid—and unexpected—rise in rates can be harder for investors to navigate. In 1994, inflation worries prompted the Fed to lift rates at a much faster clip over a shorter period of time—and without advance notice. The 10-year US Treasury Index lost nearly 4% during that cycle.

US high yield, however, was up 1.4%—evidence that active bond managers can still deliver positive returns even when Treasury prices fall, by using insights on valuation and credit quality to choose bonds that can withstand broader market downturns.

Today’s conditions more closely resemble those in 2004: the economy is gaining traction at a measured pace, inflation remains under control, and policymakers have tried to avoid surprises by clearly telegraphing their plans to financial markets. Under such conditions, bonds tend to do well.

How to Position Your Portfolio

So how should investors prepare? Those with high-income strategies can diversify their interest-rate and economic risk by taking a global, multi-sector approach. This could involve adding sectors such as US securitized assets, which benefit from strong credit fundamentals and consumer spending.

Such an approach might also involve a higher allocation to emerging markets, which stand to gain from stronger US and global growth. We see opportunities in some attractively valued local currency–denominated bonds from countries that are cleaning up their public finances and bringing inflation under control.

US high yield is in the later stages of the credit cycle. That means investors should be choosy about what they buy. But they shouldn’t avoid this market altogether. High-yield bonds are less sensitive to interest rates than other bonds are. And their steady income can enhance total portfolio returns even as rates rise.

Investors who want to maintain a lower risk profile might want to consider a barbell strategy that mixes interest-rate and credit risk and adjusts the balance as conditions and valuations change.

Even as rates rise, this approach would involve US Treasuries and other government bonds, which provide important diversification to credit exposure in all environments. Over the medium term, more than 90% of US Treasury returns come from the yield. That means that rising rates can dramatically boost income for investors who are not primarily focused on short-term price fluctuations.

Bonds are a critical source of income and a useful diversifier of riskier equities. Rising interest rates may cause some short-term volatility, but investors with a multi-year investment horizon are likely to benefit over time as rates rise.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.

About the Authors

Matthew Sheridan, CFA

Matthew Sheridan is a Senior Vice President and Portfolio Manager at AB, primarily focusing on the Income Strategies portfolios. He is a member of the Global Fixed Income, Global High Income and Emerging Market Debt portfolio-management teams. Additionally, Sheridan is a member of the Rates and Currency Research Review team and the Emerging Market Debt Research Review team. He joined AB in 1998 and previously worked in the firm’s Structured Asset Securities Group. Sheridan holds a BS in finance from Syracuse University. He is a CFA charterholder. Location: New York

Gershon M. Distenfeld, CFA

Gershon Distenfeld is a Senior Vice President, Director of Income Strategies and a member of the firm’s Operating Committee. He is responsible for the portfolio management and strategic growth of AB’s income platform with almost $60B in assets under management. This includes the multiple-award-winning Global High Yield and American Income portfolios, flagship fixed-income funds on the firm’s Luxembourg-domiciled fund platform for non-US investors. Distenfeld also oversees AB’s public leveraged finance business. He joined AB in 1998 as a fixed-income business analyst and served in the following roles: high-yield trader (1999–2002), high-yield portfolio manager (2002–2006), director of High Yield (2006–2015), director of Credit (2015–2018) and co-head of Fixed Income (2018–2023). Distenfeld began his career as an operations analyst supporting Emerging Markets Debt at Lehman Brothers. He holds a BS in finance from the Sy Syms School of Business at Yeshiva University and is a CFA charterholder. Location: Nashville

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Worried About Rising Rates? Here’s Why You Shouldn’t Be

Why You Should Want Rates to Rise

How to Position Your Portfolio

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