Benefits of using individual bonds in a rising interest rate environment

The 10 year maturity U.S. Treasury Note (UST 10yr) is thought to be the primary benchmark for the U.S. bond market because it has the largest issuance and is used as the basis for fixed rate mortgage pricing. The 30 year historical average of the yield on UST 10yr is 5.93%. Currently, it is 2.91%. The yield reached an all-time low of 1.36% in July 8, 2016. The duration (measure of a bond’s price sensitivity to a change in interest rates) of the UST 10yr is 9 years.

The rule of thumb for understanding duration risk is that for every 1% increase/decrease in interest rates, the price of a bond falls/rises by the bond’s duration. Therefore, at current levels the maximum price return for UST 10yr is 18% calculated as follows: the yield declines from 2.91% to 0% and the price rises by 2.91 x 9yr duration or 26.19%. We believe that the possibility of this happening in the next 2-4 years is highly unlikely. In our opinion, it is much more likely that the yield on the UST 10yr could rise by 2% or more in the next 2-4 years. A 2% rise in the yield of the UST 10yr would result in an 18% decline in the price of the bond. Investors are not being paid to take interest rate risk via owning long maturity/duration bonds in the current economic environment. The duration of the bond portion of our clients’ portfolios currently is approximately 4.4 years.

In a rising interest rate environment, the risk that investors have in owning all bond mutual funds and/or bond ETFs for their bond allocation is that both vehicles are managed on a relative return basis versus a benchmark index. What this means is that bond sector allocations and portfolio duration for mutual funds will not deviate too far (10-20% at most) from the sector allocations and duration of the benchmark index. The bond sector allocations and duration of passively-managed ETFs will not deviate at all from the benchmark index. Relative return bond mutual funds and ETFs tend to have fairly constant durations. Therefore, if rates rise, investors in the bond funds and ETFs will experience price declines commensurate with the funds’ durations.

A bond allocation comprised primarily of individual bonds provides much more flexibility as it relates to duration management and tax efficiency. In a rising interest rate environment, individual bonds can be sold quickly to minimize duration risk (price declines) by reducing duration significantly (>20%) if warranted. Unlike mutual funds, individual bonds provide the investor with the ability to control the timing of gain/loss realization and the resultant tax impact. Unlike mutual funds, individual bonds mature at par letting the investor know exactly what they will earn if the bond is held to maturity. A portfolio comprised primarily of individual bonds offers more transparency of security holdings than shares of bond mutual funds which are only required to publish actual bond holdings at quarter-end. Lastly, unlike bond mutual funds which can only be purchased or redeemed at end of day, individual bonds can be bought and sold throughout the day providing the investor with more immediate liquidity.

We at DT Investment Partners are not forecasting a significant rise in bond yields within the next 2 years due to the following reasons:

  1. Demand will remain strong/prices high and yields low thanks to the need for income and portfolio stability by rapidly aging populations in Japan, Europe, and U.S.

  2. Although edging slightly higher, inflation remains in check due to globalization and technological advances.

  3. The Fed will continue raising interest rates at a very “gradual” and well-telegraphed pace expecting to move this year in three 25 basis point increments.

  4. The cost of interest payments on the enormous debt load incentivizes the government to keep interest rates at a moderate level.

  5. Pension fund managers are rebalancing funds by shifting money to bonds after strong stock market performance for most of the past 8 years.

  6. There is an abundance of global savings that needs to find a home and will not/can not all go to stocks.

  7. In times of volatility, uncertainty, and elevated geopolitical risks, U.S. Treasuries and the dollar continue to be viewed as safe haven assets.

  8. Fears of significant deficit widening may be overblown. It’s very doubtful that the Republican-controlled House of Representatives will pass the President’s deficit-widening proposed budget. Tax reform enacted late last year may encourage businesses to invest in more profit-maximizing opportunities which would lead to higher tax receipts (revenue) for the Federal government.

  9. Yields on U.S. government bonds are already some of the highest in the sovereign debt markets and are attractive to non-U.S. buyers on an absolute and relative basis. The 5 year maturity government bonds yields in Japan and Germany are negative and slightly above 0%, respectively.

The 35 year bull market in bonds most likely ended on July 8, 2016 when the 10 year maturity U.S. Treasury Note yield hit an all-time low of 1.36%. Although we believe the rise will be gradual in nature, the long-term risk for bond yields is now more to the upside than the downside. Utilizing individual bonds for a majority of the bond portion of
an investor’s portfolio would serve to minimize this risk.

 

Andrew C. Zimmerman - Chief Investment Strategist, DT Investment Partners

 

Note: DT Investment Partners’ commentary discusses general developments, financial events in the news and broad investment principles. It is provided for information purposes only. The material represents an assessment of the market environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results. Investments in various asset classes entail different investment risks. For example, small cap equities tend to be more volatile than large or mid-cap equities. International equities and emerging markets have exposure to currency fluctuations, foreign taxes, political instability and the possibility for illiquid markets. Fixed income investments involve interest rate and credit risks among others. Real estate investing includes risks such as declines in value of real estate, changing economic conditions, tax laws or property taxes. Commodities’ investing is highly volatile and subject to changing economic conditions and the vagaries of speculators among other risks. Further, diversification and strategic or tactical allocation do not assure profit or protect against loss in declining markets. Index performance returns do not reflect any management fees, transaction costs or expenses. One cannot invest directly in an index. Past performance does not guarantee future results.