• Investment Management

Preparing For A Rate Hike

With the Federal Reserve poised to raise rates, it’s time to take stock of the way you invest in bonds, says portfolio manager Jim Caron at Morgan Stanley Investment Management.

Who knows anything about bonds? Watching the stock market is an American obsession—the number of enabling apps is proof enough—but all that most people know about fixed-income securities is it’s a good idea to have more of them as you get older.

For the past 30-odd years, that’s worked. With interest rates steadily falling over that period, most bond portfolio managers offered retail investors good total returns simply by replicating allocations in major bond indices. Yet that could all change if the Federal Reserve raises rates before the end of this year. Although the Fed kept rates steady at its September meeting, most of its policy makers indicated they still expect to move this year.

When interest rates rise, bond prices fall, which impacts total returns. Investors will have to decide whether they want to continue passively following an index, which could potentially end the year with negative total returns, or actively seek out more dynamic investment strategies to boost those returns – a move that has inherent additional risks as a fund manager strays from the index.

Is Passive Broken?

To be sure, the passive strategy of ‘benchmarking’ a bond fund’s performance to an index like the Barclays US Aggregate Bond Index has worked for quite some time. The so-called Barclays Agg includes most US-traded investment-grade corporate bonds, Treasuries and other high-quality fixed-income securities. If portfolio managers did nothing but replicate it since 1981, their annual total returns would have averaged 8% in the Barclays Global Aggregate Bond Index1. Little wonder that so many people haven’t questioned the passive strategy. Why fix what’s not broken?

The problem is that Treasury yields are already hovering around record lows, and if the Fed does start raising its federal funds rate by December, which Morgan Stanley economists believe it could, then it will make the great bull run in interest rates a relic of the last 30 years.

“About 85% of that 8% average return on the Barclays Agg has come from declining Treasury rates,” says Jim Caron, fixed income portfolio manager at Morgan Stanley Investment Management.2 “The problem is we’re not likely to see the same kind of interest rate declines in the next 30 years as we’ve had over the past 30.”

Coupons at Historic Lows

Already investment-grade aggregate index returns are near zero or negative. The Barclays Agg’s year-to-date return was just 0.5% in August, and the Barclays Global Aggregate was negative 1.9%. Essentially, when it goes negative, you’re paying for the privilege of owning someone else’s debt.

Apart from the few years when there’s been a shock to the system or rates have spiked, the Barclays Agg has been able to stay in positive territory during rate hikes3, because corporate coupons have been large enough to offset falling bond prices.

The difference this time around is that coupons are now hovering around 3% for the average single-A-rated corporate bond. That’s almost half what they were in 2007.4

“Coupons are so low now that there’s very little cushion against falling dollar prices of bonds,” says Caron. “That’s why it’s going to be harder to make positive total returns by strictly following an index.”

Finding Opportunities

The nice thing about following a high-grade aggregate index is that if you’re close to retiring, you know exactly what your fund manager can and can’t do with your money.

Caron argues, however, that if indices are slipping into negative territory, a portfolio manager has the potential to boost returns by straying from the index, to pick assets from other fixed income markets that might look cheap. And if the Fed’s raising rates, look for high quality government bonds in other countries where rates are on a downward trend.

“There are other countries still trying to stimulate their economies by keeping rates low,” he says. “Look at the European Central Bank. It’s keeping rates low, as the Fed did, which means there could be some opportunity to make returns in certain government bonds in the region.”

Seeking outperformance by venturing beyond the index is easier said than done, is more difficult for individual investors to keep up with, and involves taking on more risk. Foreign securities are subject to currency, political, economic and market risks, for example.

“Both strategies have their pros and cons,” says Caron. “But one thing we do know is that a Fed rate hike will be a wake-up call to investors that it’s time to at least get to know what bond investment strategy you’re following, and if it’s the right one for you.”

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