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The Recent Rise in Interest Rates Provides Fixed Income Investors an Opportunity for a Brighter Future

With the first quarter over, many bond investors have been left scratching their heads and wondering – what just happened?  For a class of investors who are not accustomed to losing money, they were quickly reminded how bond math works – as interest rates rise, the value of bonds fall.  To some investors, a glance at their quarter-end brokerage statements may have felt more painful than a quick Will Smith slap across the face.  However, one thing is for certain, there was no “Oscar winning” performance for bond investors during the first quarter.

The first quarter ended with the broad fixed income markets, as measured by the Bloomberg U.S. Aggregate Bond Index*, returning -5.93%.  The negative performance was primarily the result of the rapid rise in interest rates across the yield curve, as investors responded to the Federal Reserve adjusting their rate hike projections due to a highly uncertain macroeconomic backdrop, heightened geopolitical tensions, and the highest inflation rates since the early 1980s. 

During the quarter, the yield curve flattened as two and ten-year Treasuries each ended March at 2.34%.  The major difference between the two benchmark maturities was the magnitude of the interest rate increases as two-year notes rose 160 basis points during the quarter, while ten-year Treasuries rose 83 basis points.  The rapid rise in yields resulted in losses for fixed income investors across the maturity spectrum with longer duration securities vastly underperforming shorter maturity bonds.  Contributing to the declines in total returns was a renewed aversion to risk, as uncertainty and volatility sparked a widening of credit spreads.

Fixed income investors came into the year knowing that return expectations should be tempered as yields started the year at a low base and spreads were at the tighter end of their historical ranges.  While many investors have been expecting and even hoping for interest rates to rise, many had probably wished for a slower path higher.  During the first quarter, the band-aid was ripped off and the cold hard reality of rising rates and negative returns came to fruition.  This type of market has been hard to fathom, even for seasoned bond veterans, as they have come to the realization that the nearly 40-year bond bull market has likely come to an end.  Keep in mind, many bond market participants have not been in the workforce long enough to experience a sustained rise in yields.  Additionally, the speed and velocity at which interest rates rose and credit spreads widened may have caught some investors by surprise. 

However, we believe there is an upside to the recent downside in fixed income returns.  All is not lost, and it is not time to panic. There is a reason for hope and optimism as the combination of higher interest rates and wider credit spreads have established a better risk/return profile and are beginning to make bonds look more attractive once again.  With the bond market rapidly repricing interest rates, it has already done some of the heavy lifting for the Fed and has priced in a considerable amount of additional Fed tightening.  The good news is that the current higher level of interest rates and the recent widening in credit spreads offer fixed income investors the potential for obtaining a greater amount of income from their investments and a brighter return profile going forward.  So, if you are considering adjusting your overall asset allocation, bonds are beginning to look more attractive and could once again be a viable option in a well-balanced portfolio.

 

The views expressed herein are presented for informational purposes only and are not intended as a recommendation to invest in any particular asset class or security or as a promise of future performance.  The information, opinions, and views contained herein are current only as of the date hereof and are subject to change at any time without prior notice.

*Source: Bloomberg Index Services Limited. BLOOMBERG® is a trademark and service mark of Bloomberg Finance L.P. and its affiliates (collectively “Bloomberg”). Bloomberg or Bloomberg’s licensors own all proprietary rights in the Bloomberg Indices. Bloomberg does not approve or endorse this material or guarantee the accuracy or completeness of any information herein, nor does Bloomberg make any warranty, express or implied, as to the results to be obtained therefrom, and, to the maximum extent allowed by law, Bloomberg shall not have any liability or responsibility for injury or damages arising in connection therewith.

 

David Dirk, CFA

Executive Vice President, Director of Portfolio Management and Trading
Boyd Watterson Asset Management, LLC