The New Fixed Income World

by on March 25, 2013 | Updated March 26, 2013 | ETFs Mentioned:

In previous blog posts, I wrote about how the economic and investment world has evolved over the past five years. Now, as the latest Federal Reserve meeting finishes up, I wanted to delve a little more into how the fixed income landscape in particular has changed, thanks in a big part to the actions of the Fed.

Here are 3 reasons why it’s not your father’s (or mother’s) fixed income landscape anymore.

  • Intentional negative real short-term interest rates. Since the financial crisis started in late 2008, nominal short-term interest rates have been close to zero and real short-term interest rates have averaged around -1.5%, much lower than their long-term average around 2%. While this isn’t the first time the United States has experienced a lengthy period of negative real rates (remember the 1970s?), it’s arguably the first time in more than 50 years that the Federal Reserve has intentionally been holding real rates in negative territory for a prolonged period of time. And as we know from the Fed’s recent pronouncements, unless the US labor market starts to heal at a much faster rate, we are likely to be in this low-rate environment for a very long time.
  • Negative and very low yields aren’t confined to the short-end of the yield curve. Even for those investors willing to go further out on the yield curve, there is little in the way of real yield. Real yields on longer-dated Treasuries are also well below their historical average. Since the 1950s, the yield on the 10-year Treasury has averaged roughly 2.5% above the rate of inflation. Today, the spread is close to zero and since late 2008, the average spread has been barely 1%. The reason long-term yields are so low: The Fed wants them that way. In recent years, the Fed has been implementing numerous asset purchase programs to drive long-dated Treasury yields – both nominal and inflation-adjusted – well below their historical average.
  • Traditional fixed income investments like Treasuries are more risky. As yields have dropped, this has the mechanical effect of raising the duration or rate sensitivity of a bond. Why? When yields drop, you get more of your total cash flow at maturity so your investment is more sensitive to where rates are at that time. The practical implication: With duration at these levels, it takes only a small backup in yields to impose significant losses on bondholders.

So what’s the bottom line for investors? For much of the last fifty years, an investor in money markets and other short-term instruments could earn a reasonable after-inflation return without taking on much risk. Today, of course, this is no longer the case.

But as bonds are still a strategic asset class providing income, stability and diversification, abandoning them isn’t the answer (even if I do like stocks more than bonds).

Instead, in this new fixed income landscape the Fed has created, bond investors must make a Hobbesian choice: accept less income or take more risk. To do the latter, investors may want to consider looking for opportunities in high-yield corporate bonds, bank loans, emerging market debt and munis, which I particularly like. These are accessible through funds such as the iShares iBoxx $ High Yield Corporate Bond Fund (HYG), the iShares J.P. Morgan USD Emerging Markets Bond Fund (EMB) and the iShares S&P National AMT-Free Muni Bond Fund (MUB).

Sources: February Market Perspectives, Bloomberg

The author is long HYG, EMB and MUB

Russ Koesterich, CFA, is the iShares Global Chief Investment Strategist and a regular contributor to the iShares Blog.

Bonds and bond funds will decrease in value as interest rates rise and are subject to credit risk, which refers to the possibility that the debt issuers may not be able to make principal and interest payments or may have their debt downgraded by ratings agencies. High yield securities may be more volatile, be subject to greater levels of credit or default risk, and may be less liquid and more difficult to sell at an advantageous time or price to value than higher-rated securities of similar maturity. A portion of a municipal bond fund’s income may be subject to federal or state income taxes or the alternative minimum tax. Capital gains, if any, are subject to capital gains tax.

International investments may involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles or from economic or political instability in other nations. Emerging markets involve heightened risks related to the same factors as well as increased volatility and lower trading volume.