Bonds Can Still Perform When Interest Rates Rise

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Includes: AGG, BHK, BND, BOND, BTZ, DBL, FBND, GBF, ICB, IUSB, JHI, JMM, PAI, PCM, PTY, RA, RCS, SAGG, SCHZ, SPAB, TAI, UBND, VBF, VBND
by: Kevin Mahn

Summary

Bonds can generally provide for a dependable and consistent stream of income and principal protection when held to maturity.

Investors should be careful not to miss out on the income and diversification potential of bonds by trying to time future interest rate hikes.

Various fixed income asset classes have provided positive performance results during certain previous periods of tightening.

It has long been our contention that, for income-oriented investors, bonds can provide for a dependable and consistent stream of income and principal protection when held to maturity. Bonds, whether they are Municipal, Government or Corporate bonds, can also provide for compounded growth opportunities when the income received from the bonds is reinvested.

Additionally, for growth-oriented investors, fixed income securities can provide investors with downside protection and diversification within a growth portfolio, especially in a highly volatile market where additional, measured, short-term flights to quality are likely.

In our view, investors should be careful not to miss out on the income and diversification opportunities offered by bonds by trying to time future, potential changes in interest rates. History has shown that trying to time the market, or time interest rate increases or decreases, is often an exercise in futility. With this said, it is important to understand that when interest rates do increase, bond prices may fall and yields may rise. However, rising interest rates should not impact the interest that bond holders receive on their bond holdings, nor should they change the ability of these investors to receive par value on their bond holdings at maturity. Bond fund investors, on the other hand, may see the interest they receive on their fund holdings change in a rising rate environment and will not receive par value at maturity as there generally is no set maturity on bond funds.

However, recognizing, of course, that past performance is not an indication of future results, history has also shown that certain fixed income asset classes have weathered previous periods of tightening. Based on research from Nuveen Asset Management (see below), three of the more recent rate hike cycles were analyzed to gauge the performance of different types of bonds during these specific periods of tightening. These time periods were as follows:

  • February 1, 1994 - February 28, 1995
  • June 1, 1999 - May 31, 2000
  • June 1, 2004 - June 30, 2006

A review of this data shows that various fixed income asset classes have provided positive performance results during previous periods of rising interest rates -- some better than others.

Source: Nuveen Asset Management, "Market Commentary: Fixed Income in a Rising Rate Environment", June 2015. Data provided by Morningstar Direct. Fixed Income asset classes displayed in the chart are represented by their relevant indexes. A list of these indexes can be provided upon request. The Securitized Debt asset class is represented by Barclays Capital Mortgage-Backed Securities Index due to limited track record of the Barclays Securities Debt Index. Market indexes do not include fees. You cannot invest directly in an index. Past performance is not an indication of future results.

I anticipate this period of tightening on the part of the Federal Reserve ("Fed") to exhibit a similar gradual and extended pace of rate hikes that we saw during the 2004-2006 time period. During this time period, the Fed raised the Federal Funds Target Rate seventeen times in 25 Basis Point (i.e., 0.25%) increments. As a result, an initial 25 Basis Point raise in December (which many now believe is highly likely) should not have a significant short-term impact on bond pricing, and is likely already priced into the market. Looking out further to the intermediate term, gradual rate hikes should likely only have a gradual impact on bond prices as well.

While allocations to bonds may vary based upon market conditions as well as investor objectives and risk appetites, certain types of bonds, from certain types of issuers, can still find a home in most investment portfolios throughout most market cycles.

Disclosure: The article above is for informational purposes and is not an offer to sell or a solicitation of an offer to buy any of the themes or securities discussed. Hennion & Walsh Asset Management currently has allocations within its managed money program and Hennion & Walsh currently has allocations within certain SmartTrust® Unit Investment Trusts (UITs) consistent with several of the portfolio management ideas for consideration cited above.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.