Quick Takes: Are Fears of Higher Rates Overdone?

Rates are rising, but the benefits of investing in core bonds remain. PIMCO portfolio manager David Braun explains why rates may be peaking, why higher rates may mean higher return potential, and how core bonds may reduce portfolio volatility.

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Text on screen: Quick Takes – Are fears of higher rates overdone?

David Braun, U.S. Fixed Income, Portfolio Manager: We all know that interest rates have risen materially from the lows established in mid-2016. 

So, we have to ask ourselves, are higher rates really a bad thing?

Yes, rising rates can certainly be painful in the short run as your bond portfolio immediately falls in value when rates rise. However, there are three reasons we think investors should consider investing in core bonds at these levels.

Chart: Line graph titled 10-yr yields have historically traded just below nominal growth plots 10-year U.S. Treasury yields and nominal U.S. GDP growth from 1955-2017.

First is our belief that the vast majority of the rate increases have already happened. Over history, 10-year interest rates have typically been below nominal GDP. Given our outlook that the U.S. economy’s potential real GDP growth rate is in the 1-1/2 to 2% range, that implies rates are likely to be relatively range bound around these levels. 

Second, higher starting rates have historically meant higher future return potential for bond investors.

Chart: Bar chart titled higher rates means higher return potential over time, plots the starting yield for the Bloomberg Barclays U.S. Aggregate Bond Index and the forward 3-year return for the same index.

This chart shows the Agg starting yield on the x-axis and the bars reflect forward 3-year returns from that point. You can see how higher starting yields leads to higher forward returns. Starting yields plus reinvestments at higher yield, buffers the price impact of rising rates. Even if rates were to move slightly higher, your starting yield is likely robust enough to overcome the initial drop in value and thus deliver positive total returns. The key point is forward looking return expectations for high quality fixed income have actually gone up.

The third reason to consider core bonds is risk management and diversification. High quality fixed income, core bonds, likely provide you with diversification versus the risk embedded in your more risky investments, namely stocks. No one has had to really think much about diversification for the past 3 to 5 years in an era of massive central bank support.

With volatility suppressed across risk markets, you did well by taking more and more risk. That’s likely not to continue as the Fed tightens and fiscal stimulus begins to wane. 

Chart: The scatter plot shows the risk and return of bonds as measured by the Bloomberg Barclays U.S. Aggregate Bond Index and stocks as measured by the S&P 500 Index. And shows that over the 20-year period, a 60/40 stock/bond portfolio has similar returns to 100% equity portfolio, with much less risk.

This simple efficient frontier chart is a good reminder of what core bonds do. You may lose some upside return potential versus an all-stock portfolio, but we think you can disproportionately reduce your risk. 

Interestingly, a lot of investors will say, with the yield curve so flat why not just park in cash and wait for the coming rate rise? While we still like opportunities in the front end you have to consider the symmetric risk around one’s base case. Yes, growth could surprise to the upside and rates could continue to rise but it could also go the other way, where growth slows and risk asset stock do poorly and interest rates fall. When that happens, you may want to have duration in your portfolio.

So, what should investors take away from this discussion?

First, we believe the bulk of the move higher in rates has already happened. Second, we believe that higher starting rates actually means higher potential returns. And finally, core bonds may provide a nice buffer in periods of stock market stress.

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Past performance is not a guarantee or a reliable indicator of future results.

All investments contain risk and may lose value. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and the current low interest rate environment increases this risk. Current reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Commodities contain heightened risk, including market, political, regulatory and natural conditions, and may not be suitable for all investors. Investing in foreign-denominated and/or -domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets . The credit quality of a particular security or group of securities does not ensure the stability or safety of the overall portfolio.

There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest long-term, especially during periods of downturn in the market. Investors should consult their investment professional prior to making an investment decision.

This material contains the opinions of the manager and such opinions are subject to change without notice. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.

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