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How a Rate Rise Reminds Us Why We Invest in Fixed Income

July 2018

Like death and taxes, the reasons to allocate to fixed income should never go away...even in the face of rising interest rates.


While it’s smart to stay current on the trajectory of rising interest rates, allowing them to change the way you think about your fixed-income investments is assigning them too much power. Like death and taxes, the reasons you should consider allocating a portion of your portfolio to fixed income should never go away.

Instead of spooking fixed-income investors, the stress caused by rising interest rates should remind us of the reasons why we invest in fixed income in the first place.

An examination of the historical performance of fixed income in the periods during and immediately following a rate rise has revealed a potentially more favorable outlook for investors who were committed to the long-term role that bonds typically play in a portfolio.

 

A Twist in the Rising Rates Plot

Typically, news of rising rates is met by fixed-income investors with as much enthusiasm as a root canal. That’s because when rates rise in the short term, bond prices generally fall and their value drops—an unpleasant proposition to say the least. It’s enough to make investors forget the reasons why they hold bonds in their portfolios and reconsider their long-term asset allocation choices.

But the fixed-income/rising rates narrative could contain a surprise twist. First of all, not all types of fixed income react the same way when rates rise. FIGURE 1 below lists the periods of rising rates and the performance of various fixed-income assets during those periods.

 

Figure 1

Rising Rates Can Affect Bond Returns Negatively

Fixed-Income Returns During Periods of Rising Rates (%)

Data Sources: Morningstar, Ned Davis Research, 1/18
We defined a period of rising rates by a 20% change in the 10-year U.S. Treasury yield.

Past performance is not indicative of future results. The performance shown above is index performance and is not representative of any fund’s performance. Indices are unmanaged and not available for direct investment. Please see back page for index definitions. For illustrative purposes only.

 

Love The One You’re (Investing) With

So why should investors consider remaining faithful to fixed income as rates rise? Over time, as bonds mature and if they are reinvested at higher interest rates, their ability to generate income can increase. Moreover, the bonds’ interest payments could also be reinvested at higher rates. Because of this, if rates rise steadily and modestly over time, investors may be better off than if rates had remained at previously low levels.

FIGURE 2 shows just how quickly bonds have recovered from the short-term price hit inflicted by a rise in interest rates. In 19 out of 19 periods, the year that followed a period of rising rates brought improved returns for the Bloomberg Barclays US Aggregate Bond Index, with returns between less than 1% and 35%, and an average return of more than 9.5%. So if investors were able to deal with the short-term hit to their fixed-income holdings, they saw their returns recover in a short period of time.

Playing the what-have-you-done-for-me-lately game with bonds can be a shortsighted proposition. When taken with the changeability of global economic conditions and market movements, it becomes clear that taking a long-term view to your fixed-income investments (and remembering their role in your portfolio) is a good way to maintain perspective in the face of short-term pressures.

 

Figure 2

Bonds Have Tended to Recover Strongly After Rate Increases

Fixed-Income Returns During the Year After Rising-Rate Periods (%)

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Data Sources: Morningstar, Ned Davis Research, 1/18
Past performance is not indicative of future results. The performance shown above is index performance and is not representative of any fund’s performance. Indices are unmanaged and not available for direct investment. Please see back page for index definitions. For illustrative purposes only.

 

This Too Shall Pass…

Investors looking to dump their fixed-income investments as rates rise may want to take a step back to avoid missing the forest for the trees. It’s important to remember that the short-term challenge of an interest-rate increase generally doesn’t supersede the long-term reasons for holding bonds in your portfolio.

One of those reasons is to serve as a potential counterbalance against volatility in the equity markets. Investors who maintain an allocation to fixed income can help offset declines in their equity holdings. And if you think diversification isn’t a compelling enough reason to consider owning an asset class, talk with investors who were “all in” on equities in 2008 and discovered they were walking a high wire without a net as the winds of volatility started to gust. FIGURE 3 shows that during the seven negative calendar years for stocks that have occured since 1977, bonds have enjoyed positive returns.

The other main reason to consider including fixed income in your portfolio is as a source of potential income. As mentioned earlier, bonds with varying levels of interest-rate sensitivity and credit risk have historically performed differently as rates rise. While the income-generating ability of traditional bonds can be compromised in the short term, other types of bonds may retain their income-generating abilities and may help offset short-term price declines.

 

Figure 3

Bonds Have Historically Had Positive Returns When Stocks Have Been Down

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Source: Thomson Reuters, 12/16

Past performance is not indicative of future results. The performance shown above is index performance and is not representative of any fund’s performance. Indices are unmanaged and not available for direct investment. please see back page for index definitions. For illustrative purposes only.

 

...But the Utility of Fixed Income Should Endure

For example, high-yield bonds have historically tended to fare well during periods of rising rates. As Figure 1 shows, the Bloomberg Barclays US Corporate High Yield Bond Index posted positive returns during rising-rate periods, averaging a return of 8.86% while the Bloomberg Barclays US Aggregate Bond Index was almost entirely in the red with an average return of -1.41%. High-yield bonds generally have a higher credit risk, because of their lower credit rating than traditional bonds. But their interest-rate sensitivity can be lower because they typically offer higher yields than many other types of bonds.

Bank loans have also tended to perform well when rates rise. They have a floating coupon that can adjust up or down on a monthly or quarterly basis as interest rates move up or down, which helps them generally have low interest-rate risk, though they are still subject to credit rate and liquidity risk.

If you’re still concerned about rising rates, there are short-duration bonds which tend to be less volatile because a rise in interest rates impacts the value of a two-year bond far less than that of a 20-year bond.

Traditionally known for their tax advantages, municipal bonds have played an important role in helping investors diversify across many macroeconomic environments, including periods of rising rates. FIGURE 4 shows how municipal bonds have historically provided positive returns during periods of rising rates over more than 20 years.

 

Figure 4

During Interest-Rate Hiking Cycles, Municipal Bonds Delivered Positive Returns

Annualized Average Monthly Return (January 1994 - December 2017)

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Source: Morningstar, Federal Reserve, 1/18. Based on the returns for the Bloomberg Barclays Municipal Bond Index.

Interest rate-hiking cycles were measured by Fed tightening cycles. The four tightening cycles since 1994 were: February 1994-March 1995, June 1999-May 2000, June 2004-July 2006, December 2015 to December 2017.

Past performance is not indicative of future results. The performance shown above is index performance and is not representative of any fund’s performance. Indices are unmanaged and not available for direct investment. Please see back page for index definitions. For illustrative purposes only.

 

The fixed-income markets can be complicated, and your financial advisor can help you choose among the wide range of options that are appropriate for you based on the interest-rate environment, how much risk you’re comfortable taking, and your investment goals.

Investment Implications:

Keep the following in mind as we make our way through a period of expected interest-rate increases:

  • Though they tend to lower bond prices in the short term, interest-rate hikes have generally led to higher fixed-income returns down the road for investors who have stayed the course.
  • Regardless of rate increases, fixed income should remain a consideration in investor portfolios to help act as a bulwark against equity volatility.
  • High-yield bonds and bank-loan exposure may be viable portfolio options for the income-seeking investor during periods of rising rates.

 

 

Hartford Funds

Morningstar ratings based on risk-adjusted return as of June 30, 2018*

  Morningstar Category Overall Rating Cat. Size 3 Year Rating Cat. Size 5 Year Rating Cat. Size 10 Year Rating Cat. Size
Fixed-Income Funds (Class-I Ticker)                  
Hartford Floating Rate (HFLIX) Bank Loan
★★★★ 205 4 205 4 165 3 76
Hartford Quality Bond (HQBIX) Intermediate-Term Bond
★★★
878 3 878 3 778 - -
Hartford Short Duration (HSDIX) Short-Term Bond
★★★★ 447 4 447 4 378 4 250
Hartford Schroders Tax-Aware Bond (STWTX) Muni National Interm
★★★★★ 261 4 261 5 233 - -
Hartford Total Return Bond (ITBIX) Intermediate-Term Bond
★★★★ 878 4 878 4 778 3 563
Hartford World Bond (HWDIX) World Bond ★★★★ 258 3 258 4 240 - -
                   
Multi-Strategy Funds                  
Hartford Balanced (ITTIX)
Allocation—50% to 70% Equity
★★★★ 674 4 674 4 617 4 439
Hartford Balanced Income (HBLIX) Allocation—30% to 50% Equity ★★★★★ 425 5 425 5 358 5 255
Hartford Checks and Balances (HCKIX) Allocation—50% to 70% Equity ★★★★ 674 4 674 4 617 3 439

1The Bloomberg Barclays US Aggregate Bond Index is composed of securities from the Barclays Government/Credit Bond Index, Mortgage-Backed Securities Index, Asset-Backed Securities Index, and Commercial Mortgage-Backed Securities Index.
2 The Bloomberg Barclays US Treasury Index is an unmanaged index of prices of US Treasury bonds with maturities of one to 30 years.
3 The Bloomberg Barclays US MBS Fixed Rate Index measures the performance of investment grade fixed-rate mortgage-backed pass-through securities of GNMA, FNMA, and FHLMC.
4 The Bloomberg Barclays US Corporate Investment Grade Bond Index covers all publicly issued, fixed rate, nonconvertible, and investment grade debt.
5 The Bloomberg Barclays US 1-3 Year Government/Credit Bond Index is an unmanaged index comprised of the US Government/Credit component of the US Aggregate Index.
The Credit Suisse Leveraged Loan Index is designed to mirror the investible universe of the United States dollar-denominated leveraged loan market.
The Bloomberg Barclays US Corporate High-Yield Bond Index is an unmanaged broad-based market-value-weighted index that tracks the total return performance of non-investment grade, fixed-rate, publicly placed, dollar denominated and nonconvertible debt registered with the Securities and Exchange Commission.
8 The Bloomberg Barclays Municipal Bond Index is an unmanaged index of municipal bonds with maturities greater than two years.
9 The S&P 500 Index is a market capitalization-weighted price index composed of 500 widely held common stocks. 

Important Risks: Investing involves risk, including the possible loss of principal. • Fixed income security risks include credit, liquidity, call, duration, and interest-rate risk. As interest rates rise, bond prices generally fall. • Investments in high-yield (“junk”) bonds involve greater risk of price volatility, illiquidity, and default than higher-rated debt securities. • Municipal securities may be adversely impacted by state/local, political, economic, or market conditions. Investors may be subject to the federal Alternative Minimum Tax as well as state and local income taxes. Capital gains, if any, are taxable. • Diversification does not ensure a profit or protect against a loss. • Obligations of U.S. Government agencies are supported by varying degrees of credit but are generally not backed by the full faith and credit of the U.S. Government. • Loans can be difficult to value and highly illiquid; they are also subject to nonpayment, collateral, bankruptcy, default, extension, prepayment and insolvency risks. • Foreign investments may be more volatile and less liquid than U.S. investments and are subject to the risk of currency fluctuations and adverse political and economic developments.

Floating Rate Fund should not be considered an alternative to CDs or money market funds. This fund is for investors who are looking to complement their traditional fixed-income investments.

This information should not be considered investment advice or a recommendation to buy/sell any security. In addition, it does not take into account the specific investment objectives, tax and financial condition of any specific person. This information has been prepared from sources believed reliable but the accuracy and completeness of the information cannot be guaranteed. This material and/or its contents are current at the time of writing and are subject to change without notice. This material may not be copied, photocopied or duplicated in any form or distributed in whole or in part, for any purpose, without the express written consent of Hartford Funds.



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