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Rising Rates and Your Bond Portfolio

Determining how your portfolio will respond to rate movements is far from an exact science, but investors should be mindful of why they're holding bonds in the first place, says Morningstar's Eric Jacobson.

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. How do the Fed's actions affect your bond portfolio? Joining me to discuss that question is Morningstar senior analyst Eric Jacobson.

Eric, thank you so much for being here.

Eric Jacobson: Good to be with you, Christine. Thank you.

Benz: Eric, let's discuss what's in the Fed's tool kit and what isn't. When we hear the Fed is going to begin raising rates, we're talking about short-term rates, right?

Jacobson: That's right. They do have some tools that can impact longer-term yields, and they have used them in the last several years; but really the focus, generally speaking, is on short-term rates--and in particular, the one that we call fed funds, which involves the price of money that banks earn when they deposit money at the Fed. It's basically like a transmission tool to affect things in the rest of the economy. It's transmitted through the banking system.

Benz: So, if I have intermediate- or maybe even longer-term bonds or some sort of bond fund in my portfolio, how should I expect to see that fund react in a period in which the Fed is raising rates?

Jacobson: Unfortunately, there is no good formula that you can just plug in and say, "If the Fed does this, my portfolio is going to do that." You would hope or think that maybe knowing the duration of your portfolio might help you with that. The problem is that that number tells you about how things are going to react to changes in rates of longer maturities or maturities that are similar to those in your portfolio; because the fed funds' rate is very, very short term, it doesn't necessarily transmit one-to-one with everything else going on at longer maturities. What it does do, however, is it affects the price of borrowing money at that short level. And because the Fed can ratchet it up or lower it down and because a lot of parts of the economy do depend on borrowing levels there, it can ripple through the rest of the bond market and the economy by changing expectations for what's going to happen in the future.

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Benz: So, assuming I have that intermediate- or long-term bond fund in my portfolio, how would I expect it to behave in a period in which the Fed is raising rates?

Jacobson: Well, I would think about it a little bit in terms of scenarios. What I mean by that is let's say that the Fed hikes because inflation is picking up and it's observable and so forth. The real question is, what is the market expecting and what does the Fed wind up doing? All things being equal, if rates go up slowly and the market is expecting it, very often, that will result in what we would call a parallel shift--effectively meaning that short rates and long rates kind of move roughly at the same time and roughly at the same amount. You're going to feel that price change more at the long end because of the maturity issue, so the value of your bond portfolio would go down in that case.

The tricky thing is that it's all dependent on if the Fed is right at the time they make a decision, how much they move when they do, when they move, and how often they move. With the situation we're in right now, we are not really sure if the Fed is doing the right thing or not; but it's possible, for example, if the market thinks that the Fed at some point gets too aggressive and raises too much too soon and potentially chokes off some growth and, therefore, potentially sucks inflation down, longer-maturity bonds, in theory, could either stagnate or yields could fall and prices could go up at the long end even while short-term rates are going up at the short end.

Benz: How about if people have bond portfolios that tend to emphasize corporate bonds perhaps more than they are invested in Treasuries and other government bonds?

Jacobson: Well, I would say this: There has always been this sense that because corporate bonds have larger yields than Treasury bonds that they are a little bit less sensitive to interest-rate shifts. There is some truth to that certainly; but the more highly valued corporate bonds are, the closer their yields are to Treasuries, and the more sensitive they are to shifts in rates. So, I wouldn't want to tell anyone, "Don't worry--your corporate bonds are going to be immune to that," because they still can be pretty rate-sensitive. Even high-yield bonds can be affected; depending on the marketplace, if yields are very tightly close to Treasuries, for example, you get more rate sensitivity.

However, more broadly speaking, it is possible to have a period of time where rates are rising, but the economy is still doing really well. Market expectations are that the economy is going to continue to do well and, as a result, you can have high-yield bonds, as an example, perform well even in a time period when rates are rising. We saw that, for example, in 1994. That was a long time ago. It's kind of a rarity. We don't often expect to see that, but it can happen. So, it's very difficult--you just want to be careful. You don't always want to think A is going to happen, B is going to happen, and C is going to happen. You can't always tie the math that cleanly from A to C.

Benz: You talk to a lot of fixed-income managers. Obviously, none of them has a crystal ball, but let's talk a little bit about some of the things you are hearing from them about what they think future Fed actions will be and what they think about the overall health of the economy as well as the rate of inflation.

Jacobson: Well, of course, it tends to be pretty fluid, and it became especially so over the last year or so because of China and the changes in oil prices--which is a complicated input that can change things in the economy even if it's the result of other things going on. Growth in China has slowed down; there are a lot of questions about if it's even slower than the numbers predict. So, to some degree, I think we've had some skepticism among managers about seeing the kind of growth that was implied by the fact that the Fed had been talking about raising short-term rates methodically but quite a few times potentially over 2016 and beyond. That was sort of the game plan that we were getting earlier on. Within the last few months, it started to look more and more like that might not happen because of slowing growth, oil prices falling, and so forth. Now it's gotten to the point where people are even questioning whether or not they should have raised rates when they did at the end of 2015.

Benz: Back in 2015, yes.

Jacobson: Right. The Fed just came out with another announcement: They did not raise rates in late January; however, the language still seemed pretty optimistic going forward. It sounded like they maybe aren't necessarily pushing the idea that they are going to be as aggressive as they were certainly, but that's kind of the plan still. They still think they are going to be [raising rates]. And I think there is still skepticism out there in the marketplace regarding how often and how much. So, I think people are bringing their expectations back in line a little bit more with what the Fed is doing. But there is a lot of concern over whether are they going to do the right thing, if they are going to overshoot, and so on.

Benz: This is a big question, but I'm hoping you can provide some counsel here. Investors have been really concerned about the bond piece of their portfolios. Can you provide any sort of all-purpose advice about how to think about this? I know for a while everybody was shortening everything up, but what should people be thinking about as they manage this portion of their portfolios?

Jacobson: Anyone who's heard me say this before is going to think I sound like a broken record, but I truly believe what you want to do is make those decisions based on your long-term planning and future goals. If you're looking to balance your equity risk with bonds, hang in there. Make a decision about what your asset allocation is. You might want to adjust it as you're getting older and your tolerance changes, but I wouldn't change it too much based on what the market is doing.

One example that I always like to give is what happened in 2008. That was the one time, for example, that everything other than Treasury bonds just went the heck in a handbasket. Treasury bonds were the only thing that did well. But if you had been worrying about bond valuations before then and had cut them out of your portfolio, you would have had no insurance effectively. That's one way to look at it: The interest-rate sensitivity--the bond portion of your portfolio--not only is it ballast for volatility, it's an insurance policy against big problems in your stock portfolio. That may be a healthy way to look at it.

Benz: Eric, great insights as always. Thank you so much for being here.

Jacobson: My pleasure. Glad to be with you.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.