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In a world in which investors are reluctant to part with CDs paying more than 5%, and where even short-term Treasury bills are offering some of the most attractive yields seen in years, why would investors think now’s a good time to add duration1 to fixed-income portfolios?

Adding duration, after all, means investing in securities that have more interest-rate risk. A “higher-for-longer” interest-rate environment is generally perceived to pose a serious threat to the value of long-term fixed-income returns.

That said, here are three reasons why investors should consider adding duration at the moment:

  1. Markets anticipate the Federal Reserve’s (Fed’s) actions
  2. Many bonds are selling at a discount2 
  3. Global uncertainties may push rates down and bond prices up 
     

1. Markets Anticipate the Fed's Actions
Fed Chair Jerome Powell has signaled a willingness to continue hiking rates if the data warrants. However, the Fed’s own expectations, based on its dot plot,3 were that the federal funds rate4 could be relatively close to what it considers its “terminal rate.”

Even when the Fed does decide to stop hiking rates, it certainly doesn’t mean it’ll immediately start cutting them. In fact, over the last five hiking cycles, the Fed has held rates steady for an average of 11 months. However, even without a cut, intermediate-duration bonds outperformed short-duration bonds and cash over the following 12 months (FIGURE 1).

 

FIGURE 1

Intermediate Duration Has Outperformed Short Duration and Cash One Year After the Fed's Last Rate Hike
Performance (%) of Bond Indices vs. Cash After Fed cycles Ended (1995-2019)

Bonds vs. Cash
by Duration
Avg. 2/1/95-2/1/96 3/25/97-3/25/98 5/16/00-5/16/01 6/29/06-6/29/07 12/19/18-12/19/19
Intermediate 11.55 16.82 11.15 13.95 6.74 9.08
Short 7.60 10.37 7.33 10.54 5.57 4.21
Cash 5.51 6.41 5.94 6.99 5.57 2.63

As of 9/30/23. Past performance does not guarantee future results. Indices are unmanaged and not available for direct investment. Intermediate duration is represented by the Bloomberg US Aggregate Bond Index. Short duration is represented by the Bloomberg US Government/Credit 1-3 Year Index. Cash is represented by the ICE BofA US 3-Month Treasury Bill Index. Please see below for index definitions. Source: Bloomberg.

 

The Fed has held rates steady for an average of 11 months over the last five hiking cycles.

 

How is that possible without a rate cut? Typically, the market anticipates Fed action before it has a chance to make any changes. Ten-year rates have been, on average, 1.31% lower from the last hike until the Fed’s first rate cut (FIGURE 2). This is a clear indication that waiting for the Fed to act heightens the risk of missing the actual market move.

 

FIGURE 2

10-Year Treasuries Have Fallen Between the Last Rate Hike and the First Rate Cut
Change in 10-Year Treasury Yields for the Past Five Hiking Cycles (1995-2019)

Date of Last Fed Rate Hike
to Date of Initial Rate Cut
Starting 10-Year Rate Ending 10-Year Rate % Change
2/1/95-7/6/95 7.66% 6.03% -1.63%
3/25/97-9/29/98 6.76% 4.57% -2.20%
5/16/00-1/3/01 6.42% 5.16% -1.27%
6/29/06-9/18/07 5.20% 4.47% -0.72%
12/19/18-7/31/19 2.76% 2.02% -0.74%
Average Rate Change -1.31%

Source: Bloomberg, 9/30/23.


2. Many Bonds Are Selling at a Discount
The past two years have been maddening for bond investors as rates came off historic post-COVID-19 lows. US 10-year Treasury rates hit an all-time low of 0.51% on 8/4/20. Since that date, the 10-year note moved more than 450 basis points,6 breaching 5% in October for the first time since 2007. This move helped create cumulative losses of approximately 15% for investors in high-quality bonds.

While it certainly has been a painful trade for bondholders, it’s created an attractive entry point for new investors. The average price for bonds in the Bloomberg US Aggregate Bond Index (the Agg)7 was a little more than $86, and the yield to worst8 was 5.39% (as of 9/30/23). In a higher-for-longer scenario, newly issued bonds with higher coupons will be added into bond funds and ETFs, while older bonds that trade at a discount will accrete back to par.9 Even if the fixed-income market was to remain flat, a 5% return would be a welcome total return for fixed-income investors.

 

3. Global Uncertainties May Push Rates Down and Bond Prices Up
Keep in mind, investment-grade bonds10 typically experience minimal defaults. The Agg consists of high-quality fixed-income assets with three main components (FIGURE 3).

 

FIGURE 3

Three Largest Components of the Agg

US Treasuries 41.5%
Agency Mortgage-Backed Securities 26.0%
US Corporates 24.7%
Total 92.8%

Data Source: Bloomberg, 9/30/23.


 

Duration: Why It Matters
Duration is the measure of a bond’s sensitivity to interest-rate changes. The statistic is measured in years, and the longer the duration, the more sensitive a bond is to rate moves—up or down. Conversely, the shorter the duration, the less sensitive to rate changes. 

Short-duration bonds generally have maturities between six months and five years. Intermediate-duration bonds generally have maturities between five and 10 years. Long-duration bonds have maturities between 10 and 30 years.


 

Downward-trending rates have typically signaled some sort of market turmoil. In these instances, high-quality bond funds with longer duration have historically shown an ability to provide diversification relative to equities and potentially provide upside for investors. The US economy has continued to show resilience in labor markets and in consumer behavior. However, there are seemingly enough cracks at home (commercial real estate, declining consumer balance sheets, slower lending) and abroad (Israel-Hamas war, Russia-Ukraine war, Chinese economic woes, UK/eurozone economic contraction) to create uncertainty about the long term, which could eventually push rates lower and bond prices higher.
 

Summary
It may seem counterintuitive to add duration now—even as rates have risen and the Fed has maintained its hawkish tone. However, current valuations are attractive and could stay that way even if the market ends up mired in a higher-for-longer state. The market generally makes its move before the Fed and the public can react. While the economy appears resilient at the moment—especially in the US—an increasingly uncertain outlook here and abroad could motivate investors to turn to bonds to help manage risk. 

 

 


 

Duration: Why It Matters
Duration is the measure of a bond’s sensitivity to interest-rate changes. The statistic is measured in years, and the longer the duration, the more sensitive a bond is to rate moves—up or down. Conversely, the shorter the duration, the less sensitive to rate changes. 

Short-duration bonds generally have maturities between six months and five years. Intermediate-duration bonds generally have maturities between five and 10 years. Long-duration bonds have maturities between 10 and 30 years.

Talk to your financial professional to help you construct a bond portfolio that's right for you.

Bloomberg US Aggregate Bond Index is composed of securities from the Bloomberg Government/Credit Bond Index, Mortgage-Backed Securities Index, Asset-Backed Securities Index, and Commercial Mortgage-Backed Securities Index.

Bloomberg US Government/Credit 1-3 Year Index is an unmanaged index comprised of the U.S. Government/Credit component of the U.S. Aggregate Index.

ICE BofA US 3-Month Treasury Bill Index is comprised of a single issue purchased at the beginning of the month and held for a full month. At the end of the month that issue is sold and rolled into a newly selected issue.

1 Duration is a measure of the sensitivity of an investment’s price to nominal interest-rate movement.

2 Bond discount is the amount by which the market price of a bond is lower than its principal amount due at maturity. A bond issued at a discount has its market price below the face value, creating a capital appreciation upon maturity since the higher face value is paid when the bond matures.

3 The Federal Reserve’s dot plot is a chart updated quarterly that records each Fed official’s projection for the central bank’s key short-term interest rate, the federal funds rate. The dots reflect what each US central banker thinks will be the appropriate midpoint of the federal funds rate at the end of each calendar year.

4 The federal funds rate is the target interest rate set by the Federal Open Market Committee. This target is the rate at which commercial banks borrow and lend their excess reserves to each other overnight.

5 Federal Reserve Summary of Economic Projections, 9/30/23.

6 A basis point (bps) is a unit that is equal to 1/100th of 1% and is used to denote the change in a financial instrument. The basis point is commonly used for calculating changes in interest rates, equity indices and the yield of a fixed-income security. 

7 Bloomberg US Aggregate Bond Index (also known as the Agg) is composed of securities from the Bloomberg Government/Credit Bond Index, Mortgage-Backed Securities Index, Asset-Backed Securities Index, and Commercial Mortgage-Backed Securities Index.

8 Yield to worst is a measure of the lowest possible yield that can be received on a bond that fully operates within the terms of its contract without defaulting.

9 In finance, accretion refers to the accumulation of the additional income an  investor expects to receive after purchasing a bond at a discount and holding it until maturity. Par is the face value of a bond, which defines its maturity value and the dollar value of coupon payments.

10 Investment-grade (IG) bonds are believed to have a lower risk of default and receive higher ratings by the credit rating agencies, namely bonds rated Baa (by Moody’s) or BBB (by S&P and Fitch) or above. These bonds tend to be issued at lower yields than less creditworthy bonds.

Important Risks: Investing involves risk, including the possible loss of principal. • Fixed-income security risks include credit, liquidity, call, duration, event and interest-rate risk. As interest rates rise, bond prices generally fall. • Foreign investments may be more volatile and less liquid than US investments and are subject to the risk of currency fluctuations and adverse political, economic and regulatory developments. These risks may be greater, and include additional risks, for investments in emerging markets. • Municipal securities may be adversely impacted by state/local, political, economic, or market conditions. Although municipal securities are exempt from federal income taxes, investors may be subject to the federal Alternative Minimum Tax as well as state and local income taxes. Capital gains, if any, are taxable. • Mortgage-related and asset-backed securities’ risks include credit, interest-rate, prepayment, and extension risk. • Diversification does not ensure a profit or protect against a loss in a declining market.

The views expressed here are those of the author. They should not be construed as investment advice. This material and/or its contents are current as of the time of writing and may not be reproduced or distributed in whole or in part, for any purpose, without the express written consent of Hartford Funds. 

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About The Author
Author Headshot
Joe Boyle, CFA, CPA
Fixed Income Product Manager, Hartford Funds

 

 

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