With the Federal Reserve board expected to increase interest rates for the first time since 2006 later this year, bond fund managers are preparing for short-term yields to rise further than those on the long end of the US Treasury yield curve.
“Our outlook is for a bear flattener,” said Kevin Dachille, institutional portfolio manager at Eaton Vance Investment Managers in Boston.
Steve Meier, CIO for global fixed income, commodities and currency at State Street Global Advisors, used the same term: “We’ll get a bear flattener,” he said.
A ‘bear flattener’ is a yield-rate environment in which short-term interest rates increase at a faster rate than long-term ones. The yield curve is normally upward sloping, so this phenomenon means rates are converging – the spread between long- and short-term rates narrows – and the curve levels out.
Bear flattening is associated with the government raising interest rates. The US Fed only controls the overnight federal funds rate. The longer-dated the maturity, the more the price (and inversely, the yield) is dictated by the market. A rate hike typically drives short-term bond prices down, and thus increases their yields, relative to securities on the long end of the curve.
A Treasury yield curve can also experience a ‘bull flattener’, which is when long-term interest rates fall faster than short-term ones. This is associated with expectations of falling inflation, and usually happens when the market anticipates the Fed will lower short-term interest rates – a move generally associated with a strong economy and a rising stock market.
A bear flattener reflects fears of inflation and increasing interest rates, which is a vote of no-confidence regarding the economy and the stock market, all things being equal.
When the yield curve is expected to flatten, investors typically go short duration and add positions on the long end of the curve.
“I’m defensive on duration,” Meier said.
Interviews with bond portfolio managers in the US suggest their outlook and tactics are more nuanced, partly because they expect US Fed rate hikes to be modest and measured, and partly because no one has experience exiting from quantitative easing.
The basic reaction among fund managers is, however, that bonds may not be attractive but they’re not ugly, either.
“The US Treasury market is expensive on the margin, but it’s not ridiculous,” said Michael Swell, a fixed-income manager at Goldman Sachs Asset Management in New York. “We don’t expect to see some kind of horrible bear market for bonds” just because the Fed begins to raise interest rates.
“The market is getting more comfortable with the idea of Fed interest rate risk,” said George Mussalli, CIO at PanAgora Asset Management in Boston. “Bond-like instruments will probably suffer, but other sectors will do well, so we’re neutral.” He cited financial issuers as one part of the bond universe that should benefit from a rising rate environment.
Jeff Moore, co-manager of global fixed income at Fidelity Management and Research in Boston, said bondholders should remember that it is very difficult to actually lose money in any given year. “You may not beat inflation, but you won’t suffer an actual loss,” he said. “In most years, you need interest-rate risk in your portfolio.”
Moore argued that the Barclays Aggregate Index, which includes all bonds issued in the US, has an average yield of 2.3% with a five-year duration. So it delivers a total return of 2.3% over five years, or 11.5%. A simply buy-and-hold strategy would get the principal returned plus 11.5x, assuming all returns are reinvested, with compounding. “It’s hard to get a negative return without a sustained shock,” he said, noting the risk-return profile is similar for global indices.
But the long end of the yield curve is a different animal to the short end. Yields here are unlikely to budge much, regardless of the Fed, because these bonds are bought by insurance companies or pension funds with long-term obligations. These investors pursue liability-driven investment strategies, meaning they buy 30-year bonds to cover long-term liabilities; there is only so much AA-rated or higher quality paper available to satisfy their long-term requirements. In a crisis the long end is affected, but any price declines from a change in the American interest rate regime are likely to be modest or negligible.