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Changing Conditions: A Bond Market FAQ

Key Points
  • Yields have surged in recent weeks, extending a rise that started this summer.  

  • The incoming administration of President-elect Donald Trump raises the prospect of new tax and spending policies that could make the fixed income market more volatile.

  • Here we address some common questions from investors and consider some of the potential changes facing the fixed income market.

The past few months have been rough on the bond market. After touching record lows in the post-Brexit vote days of early July, 10-year Treasury yields are now up more than a full percentage point. Yields jumped after President-elect Donald Trump’s election in November, due in part to expectations that a new era of tax cuts and increased government spending could stoke inflation and open the door to a sharper rise in interest rates.

Ten-year Treasury yields have jumped since the election

Source: Bloomberg. 10-Year Treasury Constant Maturity Rate (USGG10YR). Data as of 12/8/16. Past performance is no guarantee of future results.

This could be bad news for bond investors, as rising yields and inflation could mean shrinking returns. Does that undermine the case for bonds? We don’t think so. Bond investors may be concerned, though.

Here we’ll address some of the questions we’ve received from investors trying to make sense of the new environment.

1. Should I avoid bonds and bond funds now that interest rates are going up?

No. It’s pretty rare that we would suggest you abandon a major asset class altogether. Whether interest rates are moving up or down, bonds are an essential part of a portfolio for most investors. Bonds generate income and help reduce overall portfolio volatility because they provide diversification from stocks. Retirees and investors with specific goals may favor bonds because they also provide a predictable amount of cash at maturity (barring a default or call), which make them useful for cash-flow planning. While bond funds don’t provide a predictable amount of cash at maturity, they still allow investors to target specific maturity ranges to meet their long-term goals.

When interest rates rise, bond prices may fall, but they also tend to stabilize over time. Rising rates can also mean more income over time. The surge in yields we've seen since this summer already means investors could potentially find more income today than they could just a few months ago.

It’s also important to have a flexible investment plan so you can take advantage of potential opportunities to generate more income as rates rise. That’s why we tend to like bond ladders composed of individual bonds spread across a range of maturities, or strategies that diversify bond fund allocations across multiple durations to avoid concentrations in parts of the market that could face higher volatility if rates rise. You could also lower the average duration of your bond portfolio—in general, lower duration bonds tend to be less volatile when interest rates rise—and keep most of your allocation to high quality bonds like Treasuries and investment grade corporate and muni bonds.

You can read more about bond ladders here.

2. My bond fund is down and the yield is low. Is it worth keeping?

The bond fund’s net asset value (NAV) may be down but you’re still earning income—and that income may increase as interest rates rise. If it’s an actively managed fund, the manager will probably seek to sell bonds with lower coupons and add bonds with higher coupons as rates move up. Over time, the NAV will probably stabilize and the income rise. If it’s a passive (index-tracking) fund, the income may also rise because maturing bonds could gradually be replaced by bonds that generate more yield, increasing the total return over time.

Yes, NAVs may fall when the Federal Reserve raises interest rates. But in previous rate-hiking cycles, most bond funds still delivered positive returns over the life of the cycle thanks to higher coupons. The roughest part was the months prior to the first rate hike and the following six months. No two cycles are the same, but focusing on total returns rather than price movements can alleviate some anxiety about what to expect.

You can read more about bond funds here.  

3. What about inflation? The new administration is talking about big spending and tax cut plans, and OPEC is cutting production to try to boost oil prices.

Yes, inflation is bad for bonds because they pay a fixed amount of income. When inflation rises the value of a fixed income payment declines. However, if inflation is a concern then you might consider Treasury Inflation Protected Securities (TIPS). When inflation rises, the principal amount of TIPS rises, boosting your income and what you receive at maturity.

TIPS are now priced for 2% inflation over the next 10 years, while the consumer price index is running at a year-over-year rate of 1.6%. If you think inflation will average 2% or more, then TIPS may make sense compared to regular Treasuries.

You can read more about the post-election landscape here.

Inflation indicators have edged up over the past year

Source: Bloomberg. Readings for each category are as of 10/30/2016 and 10/30/2015.

4. What is going to happen with the Fed?

The Fed looks set to raise its benchmark federal funds rate at its Dec. 14 meeting. We think two or three more hikes are likely to follow, bringing the fed funds rate to the 1%–1.5% region by the end of 2017. We expect 10-year Treasury yields to trend higher over the course of the next year, ending the year in the 2.5%–3.0% vicinity. The Fed will say more about its outlook and offer other insights at its post-meeting press conference, and we’ll be keeping an eye on economic data releases. The employment figures will be the most important.

The November employment report was good enough to justify a possible Fed rate hike this month, but not indicative of an overheating economy. On the positive side, job growth at 178,000 is consistent with a healthy economy, and the 4.6% unemployment rate is a new low. The “underemployment rate” also dropped to a new low for the cycle of 9.3%, which is encouraging.

On the not-so-positive side, the unemployment rate dropped mostly because of a decline in the size of the labor force and fewer people getting laid off, as opposed to a lot of people gaining new jobs. Moreover, the labor force participation rate dropped. It wasn’t a huge decline, but it would be good to see it move higher. The 2.5% increase in average hourly earnings was below the 2.8% rise the previous month.

Looking ahead, Fed Chair Janet Yellen’s term ends in February 2018, and Vice Chair Stanley Fisher’s is over in June 2018.  Both have indicated they intend to finish out their terms, but it seems doubtful that they will be reappointed, as Trump has been highly critical of their policies. Over the course of the next few years, it’s possible that the new president will fill several seats on the rate-setting Federal Open Market Committee, which could change the FOMC's approach to policy.

5. What should I do about my muni bonds?

The municipal bond market has sold off since the election due to the potential for tax law changes and increased issuance to fund infrastructure spending. One of munis' chief attractions is that their interest payments are generally exempt from federal and possibly state income taxes. Lower tax rates could dent their appeal and push down prices. Increased supply could also hurt. 

However, investors need to remember that nothing has changed yet. Congress, not the president, will be writing any changes to tax law. While it’s normal for the market to react to a shift in expectations, actually implementing any changes will take time. We wouldn’t expect changes to current tax law to go into effect until late 2017 or early 2018. Moreover, it’s likely that tax exempt income will continue to be attractive to many investors. The recent selloff may be an opportunity to pick up some muni bonds at good yields.

You can read more about munis here

6. The dollar is strengthening. Do I need to worry about my international developed and emerging market bonds?

We’ve been suggesting investors reduce their exposure to international developed market bonds for a while now. Yields were quite low relative to what’s available in the U.S., and we are bullish on the dollar, which adds to currency risks.

The picture is slightly better for emerging market bonds, but we’re still cautious. EM bonds have fallen quite a bit in recent months as the dollar has strengthened. Emerging market issuers with large dollar-denominated debts could be a source of concern. Corporate borrowers have accumulated $1 trillion in such debt.

There is a possibility that the U.S. will adopt protectionist measures on trade. Many emerging economies rely on trade to drive growth, so a protectionist turn in the U.S. could hurt. It is hard to say how all of this is going to play out. We would remain cautious.

Barclays Emerging Market Local Currency Government Bond Index

*Currency Return may include paydown return.

Source: Bloomberg Barclays Emerging Markets Local Currency Government Bond Index. Annual data, with 2016 YTD data as of 12/7/2016. Past performance is no guarantee of future results.

7. What should I do with my preferred securities? Between the steep rise in long-term yields and the problems with European banks, should I be nervous?

Preferred securities have gotten hit pretty hard over the past few weeks. Such securities tend to have very long durations—most preferreds are perpetual securities, meaning they have no maturity date—and the long end of the fixed income market has sold off sharply due to the spending and inflation expectations mentioned above.

However, the Bank of America Merrill Lynch Preferred Securities Index is still up 1.5% for the year so far. How is that possible? Preferreds tend to offer high coupons—around 6%.

Preferred securities share characteristics of both stocks and bonds and can be quite volatile at times. The long durations and high concentrations in the financial sector are potential sources of risk. News that the U.S. Department of Justice had proposed that Deutsche Bank pay a $14 billion fine to settle an investigation also rattled the markets and raised concerns about the health of European banks.

Despite all that, the higher coupons may be worth it relative to that risk. We still feel preferreds should serve as a complement to, not a substitute for, your core fixed income holdings, and should be considered long-term investments.

You can read more about preferreds here.

What can you do now

Look at what you hold and think about why you hold it. You should also consider talking with a Schwab fixed income specialist. Are you comfortable with the plan that you’ve laid out? Is it time to re-balance because some investments have done well and others have fallen? Once you’ve done that, it’s probably best to sit back and wait to see what will happen with the new administration.

And from a big picture point of view, we believe we probably won’t see a return of the low yields we saw over the summer until the next recession. For income-oriented investors, this could be good news.

Next Steps

  • Call Schwab anytime at 877-338-0192.
  • Talk to a Schwab Financial Consultant at your local branch.
  • Follow Kathy Jones on Twitter: @kathyjones
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