'Bondageddon' could be back — here's how to protect your portfolio

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Talk of a “Bondageddon” is back again.

Commentators have repeatedly invoked the fear that investors could suddenly flee the bond market, causing prices to collapse in their wake, ever since the Federal Reserve lowered short-term interest rates to near zero and began its bond buying programs back in 2008. Former Federal Reserve Chairman Alan Greenspan provided an example of the genre when he warned in a recent TV interview that bond yields are unsustainably low and that the market is in a bubble. Such concerns have proved durable despite the fact that previous bouts of Bondageddon talk haven’t borne out.

So what’s our view?

Bubbles need exuberance

We think bond yields are likely to rise from current levels as the economy continues to improve and the Federal Reserve tightens policy, but we don’t see a bubble in the market. There is no standard definition of what constitutes a market bubble, but Investopedia’s definition—“a surge in asset prices unwarranted by the fundamentals of the asset and driven by exuberant market behavior”—seems reasonable to us.

By that measure, the bond market doesn’t appear to be in a bubble. It’s hard to find investors who are exuberant when yields are so low. Moreover, since bonds have a stated yield to maturity, it’s pretty clear what the return on investment will be for a given security, barring default. These days, those returns are hardly cause for exuberance. Schwab’s capital markets expectations for the next ten years suggest U.S. investment grade bond returns will be just 3.1% per year.

Nor do bond yields appear substantially lower than warranted by current fundamental factors. Slow economic growth, low inflation, easy central bank policies, and strong investor demand for predictable income-generating assets are fundamentally supportive to the bond market. Longer-term, we still expect yields to remain below the levels that prevailed before the financial crisis.

It’s also worth noting that the last time bond yields experienced a big short-term jump, it wasn’t a disaster for most investors. Even though past performance does not indicate future results, in 2013, when yields rose by 100 basis points across the yield curve in a short period of time, the total return of the Bloomberg Barclay’s Aggregate Bond Index for the full year was –2.0%—hardly a Bondageddon scenario.

Even in bond bear markets, negative returns are rare, 1954-1981 

The Schwab Center for Financial Research with data provided by Morningstar, Inc

Fundamentals are changing—gradually

However, we don’t want investors to be complacent about the potential for yields to move up moderately from current levels because some of the factors that have driven rates lower are beginning to shift. Global economic growth is picking up and we expect further improvement in 2018. According to the IMF, no major developed country or region is in recession. That may not sound like a big accomplishment, but it is the first time that has happened since 2010 and may signal that the global economy is finally recovering from the financial crisis and recession.

Charles Schwab & International Monetary Fund. Data from the World Economic Outlook Database, as of 4/2017.

With economic growth picking up in the major regions of the global economy, the risk of deflation has receded in many countries, allowing central banks to pull back from the very aggressive monetary policies of the past decade. The European Central Bank (ECB) is expected to signal that it will begin slowing down its bond-buying program in the months ahead.

The U.S. Federal Reserve has already begun the process by raising the fed funds rate four times in the past two years. We think there is potential for the Fed to raise the fed funds rate even with inflation below its 2% target. Short-term interest rates are still negative in “real” terms—below the inflation rate. That’s not an appropriate policy stance for an economy that’s growing steadily. The labor market is improving and there are signs that wages are gradually picking up for many workers. Also, the global economy is steadily improving, so the risk of deflation has faded. Financial conditions have eased since the Fed began raising rates, due to a weaker dollar and a rising stock market.

Charles Schwab. Bloomberg. U.S. yield curve (I25 US Treasury Actives Curve as of 08/21/17) and PCE Deflator (PCE DEFY Index as of 6/30/17).

We also expect the Fed to begin shrinking its balance sheet this fall by ceasing to reinvest the principal from maturing bonds. Without the Fed investing as much, private sector investors will need to increase purchases. Yields on longer-term bonds may need to move higher to attract more buyers into the market.

Our biggest concern is that the market doesn’t appear to be anticipating the tightening in monetary policy or the potential for even modestly higher inflation. Based on futures prices, the market is anticipating only two rate hikes by the Fed by the end of 2018, while the Fed’s projections suggest the potential for four such hikes. While the market has been more accurate at forecasting than the Fed over the past few years, it’s ultimately the Fed that decides how many times to hike rates.

Inflation expectations are also quite low, which is a potential risk to longer-term bond investors. Despite rising consumer confidence, inflation expectations continue to fall. Even a small upside surprise in inflation could cause bond yields to rise.

Charles Schwab via Bloomberg. University of Michigan Index of Consumer Expectations and University of Michigan Index of Consumer Sentiment. Monthly data as of 8/18/17.

The “term premium,” or extra yield investors get to compensate for the risk of higher short-term interest rates due to inflation, is negative for 10-year bonds. That suggests the market isn’t prepared for Fed tightening. We wouldn’t be surprised to see yields move up about 25 basis points to around 2.5% later this year. That isn’t a big increase, but investors may want to be prepared for it.

Valuations matter

We are also seeing signs of complacency in the riskier parts of the fixed income markets. Yields for most credit-sensitive bonds are quite low relative to Treasuries, both domestically and in other major developed countries. These high valuations leave little risk premium for investors in the event that market fundamentals shift.

 Bloomberg Barclays. Indexes representing the investment types are: Bloomberg Barclays U.S. Corporate High-Yield Bond Index (High Yield), Bloomberg Barclays Emerging Market USD Aggregate Index (Emerging Market USD Aggregate), Bloomberg Barclays U.S. Corporate Bond Index (Investment Grade). Data as of 8/18/2017.

Note: Option-adjusted spreads (OAS) are quoted as a fixed spread, or differential, over U.S. Treasury issues. OAS is a method used in calculating the relative value of a fixed income security containing an embedded option, such as a borrower’s option to prepay a loan.

Municipal bond market valuations have moved up as well, particularly for bonds with short-term maturities. The yields on AAA-rated short-term municipal bonds are significantly above the yields on Treasury bonds of the same maturity. It appears that investors are piling into short-term munis due to concerns about the impact of tax reform longer-term. Given the high valuations, we would favor focusing on maturities of five to 10 years.

Bloomberg, as of 3/23/17 via Charles Schwab

What to do

We suggest managing the duration in your bond portfolio to mitigate the risk of rising rates. Reducing the average duration of your portfolio to less than seven years and/or using bond ladders to spread out maturities over time can be useful in reducing potential volatility. Take your investing time horizon into account. If you have a long time horizon, you should be able to ride out the ups and downs of interest rates. However, if you have a short time horizon, a market correction could have an adverse effect on your total return.

We also suggest managing your exposure to the higher risk parts of the fixed income markets where yields are low and the risk premium offered versus Treasuries is low.

Fixed income investments are an important part of a portfolio, providing income and helping to reduce volatility by offering diversification from equities. Managing duration and credit risk can help mitigate the impact of volatility within the fixed income allocation. Remember that a selloff in the bond market can provide an opportunity to add income to a portfolio with lower risk that is currently available.

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