What Higher Rates, Inflation Could Mean for Bond Investors

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. So far in 2018 interest-rate worries have been spooking bond investors. Joining me to provide an overview of the bond landscape is Sarah Bush. She is director of fixed-income strategies in Morningstar's Manager Research Group.

Sarah, thank you so much for being here.

Sarah Bush: Thanks for having me today.

Benz: Let's talk about what has really been roiling the bond market so far in 2018. It seems that investors are concerned about interest rates, the pace of Fed tightening. I know you and the team are very much in touch with some of the top fund managers out there. What are you hearing in terms of their expectation about the trajectory and velocity of interest rates?

Bush: First just to start off with the Fed, you are right--the economy has been strong. I think, really importantly, the global economy has been strong. That's been something that's not been the case for several years. I think that people are looking at the Fed and sort of expecting, consensus is kind of three to four hikes during the course of this year. I think a lot of people think that's kind of getting priced into the market.

The next question then is, what happens to longer-term interest rates. If you are in an intermediate-term bond fund, you are not necessarily holding the shortest bonds, but you are a little bit farther out the yield curve in longer maturity bonds. We've seen rates on the 10-year Treasury come up pretty noticeably year to date. I think we're at 2.85 plus or minus today. We've been hovering around that.

As we talk to the managers out there, there's some diversity of opinion. I would say there aren't a lot of managers, with a few exceptions, there aren't a lot who think we are going to go way higher from this point. You hear people talking about 3%, 3.25% as being fair …

Benz: Not 5% or 6%?

Bush: Not 5% or 6% for the most part, there with a few exceptions. TCW MetWest Total Return, which is a fund that's been kind of bearish on interest rates, they have mentioned that they are getting closer to neutral as we're kind of moving toward that 3% number. One other view, PIMCO is a little bit more concerned that rates could go a little bit higher just because inflation is picking up, and I know we are going to talk about that a little bit later on.

One interesting thing though that I've heard is, we think everybody thinks they definitely see this increase. It could go on, but that at a certain that it might start to hurt risk assets and hurt the economy, and then you could actually see that as a reason why the Fed would slow down, and rates would come down eventually. Maybe not this year, but looking out a little bit further--not necessarily that we are kind of on this constantly upward sloping trajectory.

Benz: Right. And just to provide a little bit of perspective, higher interest rates, even though they hurt bond prices in the short term, they are not an unadulterated evil for bond investors, right?

Bush: Right. Exactly. And this is something Dan Fuss always says. He says I want rates to go up, because as a bond investor, yield is basically the bulk of your total return. Higher yields mean you are getting paid more, and you should have better outlook over the long term for your returns.

Benz: Let's talk about credit bonds. One thing we've observed is, certainly as interest rates have trended up a little bit, the credit-sensitive bonds have held their ground better than the high-quality bonds, certainly long-term high-quality bonds. When you talk to managers, what are you hearing about the outlook for credit in terms of how they are positioning their portfolios? Are they feeling a little bit more defensive at this point given the rally that we've seen in some of the noninvestment-grade bonds or the lower quality bonds?

Bush: Corporate bonds, if you look over the long haul, they have done very well since the credit crisis. We had some real weakness in 2014-15, but then post-2016 again they have done really well. It's definitely been a strong performing part of the market. Managers, I think there's a couple of pieces to this. First of all, if you think the economy is good, you should think corporate credit is going to do reasonably well. But, that being said, investors are not getting paid as much for the default risk, and we are getting late in the credit cycle. So, we've had a pretty long period …

Benz: It's been going on for a while.

Bush: … Right, where lower-quality credits are doing well. Even Loomis Sayles, which is always a pretty aggressive manager when it comes to corporate credit, they have been building cash in their portfolios. You look at a PIMCO, TCW MetWest Total Return, pretty conservative on credit. That's not an area where people are finding tons of opportunities today.

Benz: You mentioned inflation and anytime we do see the economy strengthening as it has been recently, and the jobs numbers have been pretty good, people get more concerned about inflation, and inflation, of course, is the natural enemy of anything with a fixed rate attached to it. What are you hearing from managers on the inflation front? Are they finding inflation-protected bonds more attractive or has that already been priced into the market? What's going on there?

Bush: Bond managers are always thinking about inflation. That's absolutely right. And we have seen, I think, people see inflation is firming up. But that being said, TIPS have actually, there's something called this breakeven inflation, which is sort of what's priced into the TIPS market, and that's come up a lot since its bottom in early 2016. I think, managers, you certainly hear some that still like the TIPS market, but I think there's a little less enthusiasm for it today just because valuations have caught up in TIPS.

Benz: When you look at non-dollar-denominated bonds, that's one pocket of the bond market that has done really well so far in 2018 as the dollar has declined a little bit, those bonds have done relatively well. Can you talk about how fund managers, like general fund managers of intermediate-term bonds, are they buying these non-dollar-denominated bonds? How are they approaching that in terms of positioning their portfolios?

Bush: That's interesting. If you think about a core fund, say, in Morningstar's intermediate-term bond category, you won't necessarily think that you have any exposure to non-dollar bonds. But some of the big shops have been using that as a tool, say, a PIMCO, or a Western Asset. That tends to be pretty small. You are talking less than 10% exposures in those portfolios or somewhere around there.

There are a few exceptions; Loomis Sayles Investment Grade and other Loomis Sayles funds as well, that's a shop that's used non-dollar quite a bit in their portfolios. They are pulling back a little bit as a part of that kind of overall de-risking. But it's something to pay attention to because it really can add some volatility to portfolios, especially when it gets to be bigger in size. World bond funds obviously are going to see more multisector funds. It's more common.

Benz: Let's talk about how bonds have performed so far in 2018. When equities have gone down, I think, a lot of investors take it as a matter of faith that when their stocks are down, their bonds will go up. We haven't necessarily seen that so far in 2018. What's going on there, and can investors still look to fixed income to be a reliable diversifier for their equity exposure?

Bush: Obviously, part of what's happened this year is somewhat what we have seen in the stock market, is worries about what's going to happen with rising rates. That's an interesting question, because for most of the past 20 years, bonds, and especially Treasuries, really high-quality bonds have done a pretty good job of moving in the opposite direction of equities …

Benz: They've been your best diversifier really.

Bush: Right, they are very, very good diversifiers. But if you look back further--BlackRock has put out some good information about this--if you look back further, sort of pre-2000, you actually see the opposite relationship. You don't know for sure what's going to happen going forward. Certainly, if rising rates are the problem for equities, bonds could be, bonds would be losing money at the same time. But a couple of things to remember. First of all, just because they are moving in the same direction doesn't mean the swings in terms of magnitude are the same. Your stock fund is probably going to be a lot more volatile than your bond fund in that situation.

Benz: There's a big difference between losing 10% and 2%.

Bush: Exactly. So, that's something to remember. Another thing that's interesting and again, this comes from BlackRock, is they were pointing out, which I think is a very important point, that cash is actually starting to yield again. It's been a very long time since that's been the case. My colleague Miriam Sjoblom wrote a Fund Spy a little bit back, earlier this year, talking about low-duration bonds are actually, because you've seen the short end of the yield curve, shorter maturity bonds yielding more, that can be an interesting place to go. Obviously, cash isn't volatile at all, but short-duration bonds, even though they can move around a little bit if rates rise, you're not seeing really big losses on that. That can still provide some diversification if you're worried about where the equity markets are and you're looking for a little bit more ballast in your portfolio.

Benz: Sarah, great guidance. Always terrific to hear your insights. Thanks for being here.

Bush: Thanks very much for having me.

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