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Shelter From the Storm

October 2018

A fixed-income forecast for a rising-rate world.


Forecasters predict a storm’s on the way. It’s unknown when it’ll arrive or how severe it’ll be when it does. Some people will heed the warnings and then go completely overboard getting ready. Better safe than sorry. Others will do absolutely nothing. Why waste the time and resources? The forecasters have been wrong too many times in the past.

This scenario could apply to a looming blizzard or an impending change in the financial markets. After years of predictions of a spike in interest rates or that the bull market would run out of steam, it’s easy to see why some investors have disregarded the predictions of economic forecasters. What will it take to make investors finally stop and prepare for what may lie ahead?

 

The Extended Forecast

Your local TV news team has talked about nothing else for the last few days. Temperatures are dropping. Humidity levels are increasing. It’s most likely going to snow.

Similarly, the cool air we feel before an interest-rate storm is beginning to blow. Investors who don’t consider the possible impact of rising interest rates today may find themselves caught off guard as interest rates normalize in 2018 and beyond. FIGURE 1 illustrates how rising interest rates could impact your fixed-income investments.

 

Figure 1

Hypothetical Impact of Rising Rates on Fixed Income

Price impact of 1% rise in interest rates1

WP430_1

Chart is for illustrative purposes only. Past performance is not a guarantee of future results. The performance shown is index performance and is not representative of any investment’s performance. Investors cannot invest directly in an index.

Source: Bloomberg Barclays, 12/17. Fixed income sectors shown to the right are provided by Barclays and are represented by the following Bloomberg Barclays Indices—Treasury Inflation Protected Securities: U.S. Treasury Inflation-Protected Securities (TIPS) Index; Floating Rate Loans: US Floating-Rate Note Index (BBB); Asset-backed securities: US Asset-Backed Securities Index; High Yield: US Corporate High-Yield Bond Index; Convertibles: US Convertible Bond Index; Mortgage-backed securities: US Aggregate Securitized MBS Index; Broad Market: US Aggregate Bond Index; Municipals: Municipal Bond 10-Year Index; Investment Grade Corporates: US Corporates Index

Change in price is calculated as New Price = (Price + (Price * Duration * Change in Interest Rates))+(.05 * Price * Convexity * (Change in Interest Rates)^2)

 

The US Federal Reserve (Fed) kept the federal funds rate, the interest rate at which banks and credit unions lend reserve balances to other depository institutions overnight, low to kickstart growth after the recession. Interest rates are calculated on that rate. After nearly a decade with interest rates near zero, they began going back up in 2015 as the Fed started to raise their target rate. The Fed is currently projected to raise its target rate twice in 2018 (FIGURE 2). Rates could rise more quickly if economic growth exceeds expectation and/or if wages, and ultimately, inflation, rise more quickly than forecast. If predictions of nearly 4% global economic growth for 2018 are correct, interest rates may increase more than expected.2

 

Figure 2

Recent and Projected Fed Rate Hikes

2015 2016 2017 2018* 2019*
1 1 1.3 2.27 2.79

*Includes projections as of 10/18
Sources: bloomberg.com and federalreserve.gov

 

Checking the Barometer 

A barometer—a tool meteorologists use to measure air pressure—can give a solid indication of changing weather patterns. A rising reading indicates a clear and sunny day while a falling one suggests cloudy and wet conditions. Similar to a barometer, the duration of the Bloomberg Barclays US Aggregate Bond Index is a helpful indicator of coming change. Duration, which is expressed in years, measures how much a bond’s price might rise or fall when interest rates change. The longer the duration, the greater the bond’s sensitivity to a change in interest rates (FIGURE 3).

 

Figure 3

Duration Risk Is Rising: Are You Prepared?

Duration of the Bloomberg Barclays US Aggregate Bond Index 

 

Source: Barclays Live, 10/18. For illustrative purposes only. 

 

In June 2017, the duration of the Bloomberg Barclays US Aggregate Bond Index exceeded six years for the first time since the late 1970s. That means an investment with a duration of six years could lose up to 6% if interest rates increase by 1%. For example, an investment of $100,000 would end up being worth $94,000.

 

More Extreme Weather Ahead?

The winter of 2017-2018 produced a string of back-to-back, intense storms—some of them dropping snow from Texas to Maine. Not only were snow totals record-setting, but the season also lasted well beyond its welcome, helping several sections of the country notch their coldest Aprils on record.3

Likewise, we’ve seen the impact a 1% hike in interest rates has on core bonds intensify, too. Fixed-income investors historically weathered that 1% increase while still bringing home a return. In today’s markets, the same rate increase could potentially offset any pickup in yield, resulting in a loss (FIGURE 4).

 

Figure 4

Core Bonds May Provide Less of a Cushion Against Rising Rates

Impact of a 1% Interest-Rate Increase on Core Bonds (9/30/18)

Source: FactSet, Data Calculation: Hartford Funds. 10/18. Core bonds are represented by the Bloomberg Barclays US Aggregate Bond Index. For illustrative purposes only.

 

That 1% increase could hurt more now than in the past because the duration of bonds has slowly risen as yields have dropped steadily. Back in 1980, an investor would have still seen a return greater than 8% over the following 12 months because the average yield on a core bond fund was more than 13%. Today, with the average yield below 3%, that 1% increase would create a negative return of -2.74% on a typical core bond fund.

 

It’s All Connected

Volatile weather patterns we see on the other side of the planet may wind up influencing the weather that’s forecasted for your neighborhood. The same is true in financial markets.

Fixed-income investing may also be impacted if equity markets show signs of greater volatility. The VIX, or the Chicago Board Options Exchange (CBOE) Volatility Index, is a key measure of near-term volatility for the S&P 500 Index—a common benchmark for US stocks. The VIX is currently at historic lows (FIGURE 5). As it heads higher, history suggests the S&P 500 Index, a market capitalization-weighted price index composed of 500 widely held common stocks, could lose momentum. If the companies represented by that index lose steam, it may have an impact on the bonds they’ve issued.

 

Figure 5

VIX and S&P 500 Index Are Negatively Correlated

 

VIX levels below 20 reflect complacency, while levels of 40 or higher reflect extremely high levels of volatility.

Past performance does not guarantee future results. Indices are unmanaged and not available for direct investment. 

Source: Morningstar, 10/18.

 

Winter Is Coming

Snowbirds, those who flee southward from colder climates, attempt to avoid snow. But despite their best attempts to avoid it, they often just find different wet weather in warmer areas. Likewise, investors who seek yield in other areas may run into bad conditions. The income-generating fixed income that has produced the highest yield is also the type that may see the biggest impact if the S&P 500 Index starts to decline. Because income-generating fixed income is so highly correlated to the S&P 500 Index, their prices are likely to decline when the Index declines (FIGURE 6).

Investors may want to consider reallocating to fixed-income sectors that are less correlated to US stocks. These include world bonds, short-term bonds, core bonds, US Treasuries, and investment-grade corporates. These investments yield less, but may be less impacted by changes in S&P 500 Index performance.

 

Figure 6

Fixed Income Can Play Unique Roles in a Portfolio

Historic Equity Correlation vs. Yield (9/30/18)

Performance data quoted represents past performance and does not guarantee future results. Asset classes are represented by the following indices: Bank Loans (Credit Suisse Leveraged Loan), Corporate High Yield (Bloomberg Barclays US Corporate High- Yield), Emerging Market Debt (Bloomberg Barclays EM USD Aggregate), Global High Yield (Bloomberg Barclays Global High Yield), Core Bonds (Bloomberg Barclays US Aggregate Bond), Investment Grade Corporates (Bloomberg Barclays US Corporate Investment Grade), Short-Term Bonds (Bloomberg Barclays US Gov’t/Credit 1-3 Yr), US Treasuries (Bloomberg Barclays US Treasury 7-10 Yr), World Bonds (FTSE World Government Bond) Source: Barclays Live, Morningstar, 10/18. For illustrative purposes only. 

 

Your Financial Meteorologist

Just like you wouldn’t trade all of your deck furniture for every shovel at the hardware store, you probably don’t want to go overboard and do something drastic in preparation. Regardless of rate increases, fixed income should remain a consideration in investor portfolios to help act as a bulwark against equity volatility.

With recent data pointing to new weather patterns for investors, it now begs the question: Is there a middle ground, a smart way someone can prepare for what’s ahead? Consider these action steps:

1. Examine the duration of your fixed-income portfolio to see how much a 1% rise in rates could impact you

2. Be clear on what role your fixed income is playing in your portfolio: volatility dampener vs. income generator

3. Examine if you should reduce equity risk within your portfolio (see below)

Now is the time to think about how you can weather the potential whiteout of interest-rate normalization. The storm might be just over the horizon. Will you be ready?

 

Reducing Risk Within Equities

Although not a substitute for bonds, here are two ways investors can help reduce risk when investing in equities.

1. Low-volatility equities
Lower-volatility stock strategies typically experience less dramatic price changes when the market goes down since fund managers aim for benchmark returns with considerably less risk. Investors who opt for this low-volatility approach maintain the long-term capital appreciation that investors look for in equities—while aiming to reduce risk exposures along the way.

2. Dividend-paying stocks
Dividends have historically played a significant role in total return, particularly when average annual equity returns have been lower than 10% during a decade.6 With interest rates currently at low historical levels, dividend-paying stocks have been appealing to many investors seeking yield. Those searching for income-producing investments may find dividend-paying stocks more attractive than today’s lower-yielding bonds.


Hartford Funds

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

(Class-I Ticker) Morningstar Category Overall Rating Cat. Size 3 Year Rating Cat. Size 5 Year Rating Cat. Size 10 Year Rating Cat. Size
Hartford Floating Rate (HFLIX) Bank Loan
★★★★ 211 4 211 4 184 3 81
Hartford Floating Rate High Income (HFHIX) Bank Loan
★★★★
211 5 211 4 184 - -
Hartford Municipal Income (HMKIX) Muni National Intermediate
★★★★
260 4 260 - - - -
Municipal Opportunities (HHMIX) Muni National Intermediate
★★★★★ 260 4 260 4 224 5 146
Hartford Municipal Short Duration (HMJIX) Muni National Short
★★★★
180 4 180 - - - -
Hartford Short Duration (HSDIX) Short-Term Bond
★★★★ 474 4 474 4 400 4 260
Hartford Strategic Income (HSNIX) Multisector Bond ★★★★ 278 4 278 4 215 3 132
Hartford Schroders Tax-Aware Bond (STWTX) Muni National Intermediate
★★★★★ 260 4 260 5 224 - -
Hartford Total Return Bond (ITBIX) Intermediate-Term Bond
★★★★ 902 4 902 4 796 3 577
Hartford World Bond (HWDIX) World Bond ★★★★ 261 3 261 4 246 - -
 

*View the full list of Hartford Funds here.

Past performance is not a guarantee of future results. Other share classes may have different ratings. The Morningstar RatingTM for funds, or “star rating”, is calculated for funds and separate accounts with at least a 3-year history. Exchange-traded funds and open-ended mutual funds are considered a single population for comparative purposes. Star rating based on a Morningstar Risk-Adjusted Return measure that accounts for variation in a managed product’s monthly excess performance (without adjusting for any sales load, if applicable), placing more emphasis on downward variations and rewarding consistent performance. 5 stars are assigned to the top 10%, 4 stars to the next 22.5%, 3 stars to the next 35%, 2 stars to the next 22.5%, and 1 star to the bottom 10%. Overall Morningstar Rating is derived from a weighted average of the performance figures associated with its 3-, 5-, and 10-year (if applicable) Morningstar Rating metrics. For more information about the Morningstar Fund Ratings, including their methodology, please go to global.morningstar.com/managerdisclosures. © 2018 Morningstar, Inc. All rights reserved. The information contained herein: (1) is proprietary to Morningstar and/ or its content providers; (2) may not be copied or distributed; and (3) is not warranted to be accurate, complete or timely. Neither Morningstar nor its content providers are responsible for any damages or losses arising from any use of this information.

The Hartford World Bond Fund (the "Fund") has been developed solely by Hartford Funds. The Fund is not in any way connected to or sponsored, endorsed, sold or promoted by the London Stock Exchange Group plc and its group undertakings (collectively, the "LSE Group"). FTSE Russell is a trading name of certain of the LSE Group companies. All rights in the FTSE World Government Bond Index ("WGBI" or the "Index") vest in the relevant LSE Group company which owns the Index. FTSE Russell® is a trade mark of the relevant LSE Group company and is used by any other LSE Group company under license. The Index is calculated by or on behalf of FTSE Fixed Income, LLC or its affiliate, agent or partner. The LSE Group does not accept any liability whatsoever to any person arising out of (a) the use of, reliance on or any error in the Index or (b) investment in or operation of the Fund. The LSE Group makes no claim, prediction, warranty or representation either as to the results to be obtained from the Fund or the suitability of the Index for the purpose to which it is being put by Hartford Funds.


1 Calculation assumes 2-year Treasury interest rate falls 0.67% to 0.00%.

2 “World Economic Outlook, October 2017 Seeking Sustainable Growth: Short-Term Recovery, Long-Term Challenges, “The International Monetary Fund, 10/17.

3 “One of the Coldest Winters in 20 Years Shatters Snow Records,” accuweather.com, 3/27/14.

4 Yield to Worst is the lowest potential yield that can be received on a bond without the issuer actually defaulting.

5 Yield-to-Maturity is the total return anticipated on a bond if the bond is held until it matures.

6 “The Power of Dividends,” Hartford Funds, 2017.

The Bloomberg Barclays US Treasury Inflation-Protected Securities (TIPS) Index consists of Treasury inflation-protected securities issued by the US Treasury with a remaining maturity of one year or more.

The Bloomberg Barclays US Floating-Rate Note Index measures the performance of USD denominated, investment-grade, floating-rate notes across corporate and government-related sectors.

The Bloomberg Barclays US Asset-Backed Securities Index is a fixed-income index that focuses on asset-backed securities. The index includes pass-through, controlled-amortization and bullet-structured securities, which have a minimum average life of one year.

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.

The Barclays Capital US Convertible Bond Index represents the market of US convertible bonds, bonds that can be exchanged, at the option of the holder, for a specific number of shares of the issuer’s preferred stock or common stock.

The Bloomberg Barclays US Aggregate Securitized MBS Index tracks the performance of investment-grade US securitized mortgage-backed securities.

The 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.

The Bloomberg Barclays Municipal Bond 10-Year Index is an unmanaged index that is considered representative of the broad market for investment grade, tax-exempt bonds with a maturity of at least 10 years.

The Bloomberg Barclays US Corporate Index is a market-weighted index of investment-grade corporate fixed-rate debt issues with maturities of one year or more.

The Credit Suisse Leveraged Loan Index is designed to mirror the investible universe of the United States dollar-denominated lever¬aged 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.

The Bloomberg Barclays Emerging Markets USD Aggregate Index is a flagship hard currency Emerging Markets debt benchmark that includes USD-denominated debt from sovereign, quasi-sovereign, and corporate EM issuers.

The Bloomberg Barclays Global High Yield Index is an unmanaged index considered representative of fixed rate, non-investment grade debt of companies in the US, developed markets and emerg¬ing markets.

The 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.

The Bloomberg Barclays US Corporate Investment Grade Bond Index covers all publicly issued, fixed rate, nonconvertible, invest¬ment grade debt.

The Bloomberg Barclays US Government/Credit 1-3 Year Bond Index is a market-value-weighted performance benchmark for government and corporate fixed-rate debt issues.

The Bloomberg Barclays US Treasury 7-10 Years Index measures US dollar-denominated, fixed-rate, nominal debt issued by the US Treasury. Treasury bills are excluded by the maturity.

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.

Important Risks: Investing involves risk, including the possible loss of principal. 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. These risks may be greater for investments in emerging markets. • For dividend-paying stocks, dividends are not guaranteed and may decrease without notice. • Fixed income security risks include credit, liquidity, call, duration, and interest-rate risk. • Investments in high-yield (“junk”) bonds involve greater risk of price volatility, illiquidity, and default than higher-rated debt securities. • Loans can be difficult to value and highly illiquid; they are also subject to nonpayment, collateral, bankruptcy, default, extension, prepayment and insolvency risks. • Mortgage related- and asset-backed securities’ risks include credit, interest-rate, prepayment, and extension risk. • 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. • The value of inflation-protected securities (IPS) generally fluctuates with changes in real interest rates, and the market for IPSs may be less developed or liquid, and more volatile, than other securities markets. • 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.

Floating Rate Fund and Hartford Floating Rate High Income 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.  

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