As we enter September, the fear of the Fed taper continues to nag markets, resurfacing every few days to keep benchmarks in check. While equities have been one of the major focuses of the taper, mainly because of the all-time highs that benchmarks hit this year, the bond market also has a number of investors worried. The current economic environment has painted a cloudy picture for U.S. debts and investors are beginning to get skittish [for more bond ETF news and analysis subscribe to our free newsletter].
Fed Fears Plague Fixed Income
Currently, the Federal Reserve has made no official comment on exactly when it will begin to taper, but its commentary suggests that it could begin any day now. While the taper speculation has infected equities with volatility, the fixed income space has even more to lose when the taper eventually occurs. “Investors fear a cutback in Fed stimulus for two reasons. First, the monthly purchases keep bond prices high and bond yields low. That stimulates the economy by holding down mortgage rates and other borrowing costs, which in turn helps boost corporate profits” write E.S. Browning and Kaitlyn Kiernan.
With the fear of the taper, bond yields have begun to move higher, putting extreme pressure on prices. As yields continue to rise, prices will take a hit, setting off what will most likely be a period of outflows for fixed income ETFs. The trend has already started in 2013 as investors attempt to rebalance their portfolios ahead of the Fed move. The chart below shows the net annual flows (in millions) of three of the most popular bond ETFs: AGG, BND and LQD.
Though AGG and LQD saw slight outflows in 2010, the next two years saw investors rush into the fixed income space as the near-zero rates from the Fed made it more difficult to find strong yields. 2013 paints a completely different picture, as all three funds have seen investors begin to sell out, with LQD taking an extremely hard hit. The taper of asset-purchasing is one of the biggest drivers behind the current outflows, but the next few years could also prove to be costly for the fixed income space [see also Bond ETFs In Focus: Defining All The Yield Metrics].
Rising Interest Rates on the Horizon?
Should the economy continue on the right track, as the Fed has forecasted, it will eventually be time to unfreeze the near-zero rates that Bernanke and company put in place. Though the timeline continues to change, it looks like rates will be frozen until 2015, when the Fed will re-assess the economy and presumably decide when rates can be raised again. When that happens, fixed income investments will be in for another rough period, as investors will be likely to sell their long-term assets for juicier yields as rates continue to rise.
Throughout the last 20 years, the Barclay’s Capital Aggregate Bond Index has turned in just two negative performances, with both of those coming in years when interest rates were raised. The index returned an average of 6.44% over that time period. As the chart demonstrates below, there have been three distinct periods in the last two decades where interest rates were raised on a consistent basis: 1994, 1999 and 2004. The index saw its only two dips of the last 20 years in 1994 and 1999 and returned 4.34% in 2004, 2.01% below the average [see also Using ETFs To Build A Complete Bond Portfolio].
The following graph shows the monthly Federal Effective Rate, represented by the blue line, versus the annual returns of the Barclays Capital Aggregate Bond Index, represented by the orange columns. The bottom axis marks the end of each calendar year.
Though it does not call for immediate panic, investors should take note that a rising interest rate typically causes general bonds to underperform. This, of course, will not apply for every facet of the bond space, as there will certainly be ETFs that will be able to perform better in a rising rate environment. Certain fixed income products carry a floating rate, allowing them to outperform the competition in an environment where rates are spiking.
It should be noted that the current rate environment is unlike that of any other, with rates frozen at historical lows for several years. Long gone are the days when you could earn 17% annually from standard interest rates, and the new rate environment has taken bonds into uncharted territory.
The Bottom Line
With the Fed taper creating storm clouds for the near-term in the fixed income space and the long-term being faced with the possibility of rising rates, investors need to tread carefully moving forward. It may be a good time to revisit your debt allocations and decide if you would be better served utilizing different techniques that may be more suited for the current environment.
Follow me on Twitter @JaredCummans.
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Disclosure: No positions at time of writing.