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February 2019

Client Conversations: Yes, Virginia, Bonds May Still Be Worth Owning When Rates Rise

When rates rise, the question may be less about whether or not to own bonds, and more about which ones make sense to own.

Client Conversations gives financial advisors an easy way to communicate with clients on topics influencing financial markets; it highlights common investor behaviors and offers ways to address the challenges investors face. Share this article with your clients, and remember to follow your firm's policies that govern sharing content with clients and prospects.

Client Conversations gives financial advisors an easy way to communicate with clients on topics influencing financial markets; it highlights common investor behaviors and offers ways to address the challenges investors face. Share this article with your clients, and remember to follow your firm's policies that govern sharing content with clients and prospects.



Raise your hand if your mother ever lectured you about wearing sunscreen. Keep it up if you ignored her and came home several shades redder than a lobster. 

Applying sunscreen may not be your first priority, but it serves an important purpose. The same can be said about owning bonds. In today’s rising interest-rate environment, you may be tempted to forego this portfolio staple—but you could get burned when volatility picks up. 

Here’s why it still makes sense to own bonds, even when rates are on the rise. 

 

Rising Rates, Falling Prices

The Federal Reserve (Fed) kept interest rates artificially low to bolster the US economy after the recession in 2008. But since 2015, they’ve been gradually increasing rates to a more “normal” level and this is expected to continue for the foreseeable future.

Interest rates have an inverse relationship with bond prices: When rates go up, bond prices generally go down and vice versa. Some bonds are more sensitive to interest-rate changes than others. For example, the longer it takes a bond to mature, the more sensitive it is to changing interesting rates: A bond that’s maturing in two years is less impacted than one maturing in 20 years—a time frame in which rates could change significantly.

 

Not All Bonds Are Created Equal

This difference in interest-rate sensitivity means that while some bonds are hurt each time the Fed bumps up interest rates, others are less impacted. In other words, it may be less about whether or not to own bonds when rates rise, but more about which ones make sense to own. 

As Figure 1 shows, leadership is constantly changing, but there are some patterns during periods of rising rates.

Figure 1: When Rates Rise, Bond Leadership Shifts

Annual Returns of Fixed-Income Asset Classes Represented by Indices as of 12/31/18

 

CCWP047_figure1

Data Source: Morningstar, Inc., 1/19.  * Data Source: St. Louis Federal Reserve, Federal Reserve H15 Report, 1/19. Past performance does not guarantee future results.  Indices are unmanaged and not available for direct investment, and do not represent the performance of a single fund or any Hartford Fund. Please see the bottom of the page for index definitions.

5 Types of Bonds That Can Generally Take the Rising-Rate Heat

  1. Global government bonds are investment-grade bonds that are less sensitive to the Fed raising rates because they originate outside US borders and aren’t subject to domestic rates.

  2. Municipal bonds are typically high quality and tend to provide consistent income that’s generally tax-free, which can help offset the effect of rising rates.

  3. Floating-rate bonds or bank loans are below-investment-grade bonds with variable interest rates. With their ability to reset their rates every 30, 60, or 90 days, they can be better-suited to changing interest-rate environments.  

  4. High-yield bonds generally have short maturity dates and compensate  for lower credit quality with higher coupons. Rising rates typically indicate an improving economy, which means companies that offer lower-quality bonds such as these may be in a better position to meet their financial obligations.  

  5. Emerging-market debt (EMD) bonds are similar to global sovereign debt in that these bonds aren’t subject to domestic interest rates, but EMD bonds are usually lower credit quality.
     

Remember Why You Started

Before you throw the bonds out with the bath water, remember what they’re there to do for your portfolio. For many investors, the two main jobs of fixed income are to generate income and diversify a portfolio. These are goals that can still be met, even when rates rise. 

For example, the volatile end to 2018 left equities negative for the first time in a decade. But bonds remained flat for the year and provided ballast—as they’ve done in each of the negative years for equities in the last four decades (Figure 2)

 

Figure 2: Bonds Have Turned in Positive Returns in Every Negative Calendar Year for Stocks Since 1977

CCWP047_figure2

Source: Thomson Reuters, 1/19

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.

 

Let Someone Else Get Your Back

The fixed-income sectors that perform well when rates rise are also some of the sectors that can be best accessed by professional, active managers. Even within the same asset class, some types of bonds may perform better than others, so it always helps to own the “right” mix of bonds at the right time—something best left to the professionals.

Active managers not only have the ability to conduct deep research into the companies and municipalities offering bonds, but their size and buying power also gives them access to bonds that the average investor does not have. And when bonds mature, a fund manager can reinvest the proceeds in new bonds, potentially at higher rates thanks to the Fed.

Talk to your financial advisor today to review your portfolio’s bond allocation and make sure you’re covered to weather all environments.





High Yield Bonds are represented by the Bloomberg Barclays Corporate High Yield Index, which covers the USD-denominated, non-investment grade, fixed-rate, taxable corporate bond market. Short-Duration Bonds are represented by the Bloomberg Barclays 1-3 Gov’t./Credit Index which is composed of the Bloomberg Barclays Government and Corporate Bond Indexes, including U.S. government Treasury and agency securities as well as corporate and Yankee bonds, with maturities between 1 and 3 years. Municipal Bonds are represented by the Bloomberg Barclays Municipal Index, which covers the USD-denominated long term tax exempt bond market. Long-Duration Bonds are represented by the Bloomberg Barclays U.S. Long Gov’t./Credit Index, which includes all bonds covered by the Bloomberg Barclays Gov’t./Corp. Bond Index with maturities of ten years or longer. Investment-Grade Corporate Bonds are represented by the Bloomberg Barclays U.S. Corporate Investment Grade Index which measures the performance of investment grade corporate bonds. U.S. Government Bonds are represented by the Bloomberg Barclays Government Bond Index, which is made up of of the Treasury Bond Index and the agency Bond Index, as well as the 1-3 Year Government Index and the 20+ Year Treasury Index. TIPS (Treasury Inflation Protected Securities) are represented by the Bloomberg Barclays U.S. TIPS Index, which represents securities that protect against adverse inflation and provide a minimum level of real returns. Global Government Bonds are represented by the FTSE World Government Bond Index, which is composed of 14 world government bond markets with maturities of at least 1 year. Bank Loans are represented by the Credit Suisse Leveraged Loan Index, which is a representative index of tradable senior-secured U.S. dollar-denominated non-investment grade loans. Cash Investments are represented by the BofAML US Treasury Bill 3 Months, which measures the performance of a single issue of outstanding treasury bill which matures closest to, but not beyond, three months from the rebalancing date. Emerging-Markets Debt is represented by the JP Morgan GBI Emerging Markets Global Diversified Index, which is a comprehensive global, local emerging-markets index, and consists of liquid, fixed-rate,  domestic-currency government bonds. Diversified Portfolio is represented by an equal portion (11.1% each for 1994-1997, 10% each from 1998-2001, 9.1% each from 2002-2018) of the previously listed indices. S&P 500 Index is a market capitalization-weighted price index composed of 500 widely held common stocks. Bloomberg Barclays US Aggregate Bond Index is composed of securities from the Bloomberg Barclays Government/Credit Bond Index, Mortgage-Backed Securities Index, Asset-Backed Securities Index, and Commercial Mortgage-Backed Securities Index.

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 London Stock Exchange Group plc 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 the 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. 

 

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. •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. 

Hartford Floating Rate Fund and Hartford Floating Rate High Income Fund should not be considered an alternative to CDs or money market funds. These funds are for investors who are looking to complement their traditional fixed-income investments. 

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