Capital Ideas^™ 
Investment insights from Capital Group

The U.S. Federal Reserve raised the federal funds target rate by 25 basis points to a range of 1% to 1.25% on Wednesday. The hike is the fourth in this cycle, signaling that the central bank’s tightening campaign is now well underway. We expect one more rate hike this year and for the Fed to begin winding down its balance sheet late in the year. However, we do not believe that these actions should be a cause for concern among bond investors.

This rate-hiking cycle is historically unprecedented – in a good way!

As bonds yields rise, prices fall – that’s just how bonds work. But while that rule always holds, it does not mean bond investors are doomed in the current tightening cycle. Monetary policymakers are raising rates very gradually to ensure that the economy is not negatively impacted by rates rising too quickly.

To understand just how unusual this cycle looks, let’s compare it to the last cycle, which began in June 2004. Over the 18 months that followed, the Fed raised rates aggressively – a total of 325 basis points to 4.25% from 1%. This time around, the Fed is not only starting at a lower rate (from between 0 and 0.25%) but over the same period of time since it began raising rates in December 2015, it has only hiked rates 100 basis points.

We believe this strategy of gradual rate hikes isn’t likely to change. This is in part because the Fed is also interested in tightening monetary policy by gradually reducing assets on its balance sheet — assets that it purchased to provide liquidity in the markets during the financial crisis of 2008-09 and to stimulate the U.S. economy through 2014. After another hike this fall, we don’t expect another rate increase until next year, as the Fed will instead likely move to begin letting assets on its mammoth $4.5 trillion balance sheet run off. Since the financial crisis, the Fed’s balance sheet has grown five times as the central bank bought a combined $3.5 trillion in U.S. Treasuries and mortgage-backed securities in an attempt to help boost the U.S. economy by keeping interest rates low.

Long-term rates should remain anchored

Investors should also remember that the Fed only has direct control over short-term rates. Longer -term rates are dictated more by market forces. Indeed, this is why we have seen the benchmark 10-year Treasury yield hover around the relatively low rate of 2.25% for the past six years, despite recent short-term rate hikes. So while short-term rates have increased by 1% over 18 months, the 10-year Treasury yield is roughly unchanged over the same period.

 

We think longer term yields should remain fairly low for an extended period, even as the Fed continues raising short-term rates, for several reasons:

• The U.S. continues to grow at a muted pace, around 2%.
• Global growth and inflation remain low, and global central bank policy is still very accommodative.
• Foreign investors continue to exhibit strong demand for U.S. bonds, as their local fixed income issues provide lower yields than U.S. bonds.
• In today’s uncertain environment, there are many potential sources of risk, such as those stemming from possible fiscal and monetary policy uncertainty and geopolitical shocks, that could result in a flight to quality and increased demand for U.S. bonds.
• As rates increase, so does demand for bonds from key groups of investors, which helps to limit how much yields can rise. Those include mutual funds, pensions and insurance companies.

Many fear that the Fed could have more impact on longer term rates as it begins to shrink its balance sheet. However, we do not find this likely. Based on how the Fed outlined its likely procedure for balance sheet reduction in its May meeting minutes, it will do so gradually and methodically, allowing a limited amount of Treasury and mortgage securities to run off each month. Currently, the Fed reinvests all of the proceeds of maturing bonds into additional bonds in order to maintain the size of its balance sheet.

By providing a ceiling, or a cap, on the amount of bonds that are allowed to mature without reinvestment, the Fed will provide a smooth path for ending its reinvestment so as to slowly – not abruptly – reduce its balance sheet. Any amount of bonds that mature above the cap will continue to be reinvested by the Fed. The cap would initially be set at a low level and raised every three months until the balance sheet size is eventually normalized. Even when normalized, it will remain historically large at $3 trillion, according to baseline projections.

Income could overshadow price declines

Since interest rates are historically low and the Fed is hiking short-term rates, some investors fear that bond fund returns may be more negatively impacted by rising yields than they have in past cycles. Although bond math tells us that bond prices fall when yields rise, the coupon earned can help to offset declines from rising yields. The ability to reinvest at higher yields also helps to offset price declines from rising rates. It’s not only about how much interest rates rise, but also about how they rise relative to the forward curve, and whether yields rise, as longer term yields may or may not react to higher short-term rates. For all of these reasons, bond fund returns are often able to prove resilient in the face of Fed rate hikes.

For a real-life example, let’s consider historical Fed hiking cycles in the context of the Bloomberg Barclays U.S. Aggregate Index, which represents the universe of U.S. investment-grade bonds. It has generally provided positive returns in these periods – even when there were more aggressive rate increases. In the seven rate-hiking cycles over the past 35 years, including the current one, only two have had cumulative losses for the index. Even in the 1994 hiking cycle, which would be considered by many to be one of the more aggressive, the index saw a loss of just 2%. The average cumulative return of the index over all seven hiking cycles was a positive 3.5%.

Core bond funds are now more attractive to investors looking for a stronger income component, particularly since prices are proving resilient despite the Fed increasing short-term rates.

Translating these expectations to portfolio construction principles

Don’t fear all duration: Since the Fed only controls short-term rates and we believe that longer term yields will remain anchored, investors should not fear all duration. We aren’t advocating that investors take on excessive duration in the form of 30-year bonds, but we think intermediate duration is attractive and makes sense in a balanced portfolio. For interest rate risk to be a bigger concern, monetary policy or the broader economy would have to experience a fairly dramatic shift from the status quo. This could occur if the global economy suddenly began growing at a much faster pace than expected or if inflation were to rise sharply. Neither possibility appears likely in our view.

Remain well-balanced: Why is the Fed so slow in its effort to normalize rates and the size of its balance sheet? Since current growth projections are modest and significant uncertainty persists across the globe, the Fed fears that tightening aggressively could hamper the economic recovery. That means investors should maintain a balanced portfolio of both stocks and bonds, especially those that exhibit a low correlation to equities.

Don’t be tempted to take on too much credit exposure: In recent quarters, credit has rallied as the stock market has flourished. Returns have been strong for both investment-grade and high-yield bonds, leading some investors to gravitate to funds with hefty credit exposures. However, when the equity market turns, the value of many of these funds can fall as well. This may surprise investors who expect those bond funds to diversify against stock declines.

Ultimately, we believe balance continues to be a good strategy with the future uncertain. And in this slow rate-hiking cycle, the Fed’s actions shouldn’t steer investors away from building their portfolio with a durable foundation of bond funds that behave like bond funds.