(PUB) Investing 2015

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What Rising Rates Mean for Your Bond Portfolio Income Strategist | Eric Jacobson

Fed’s short-term rate hikes. (The second chart shows short- and long-term rates nearly moving in tandem, a so-called parallel shift in the yield curve.) The 10 -year Treasury lost 7 . 9% in 1994 ; the 30 -year bond slid more than 12% .

Fed Funds Hikes: How the Market Responded in the Early 1990s

Yield (%)

Rising rates are the bond market’s boogeymen, but the market doesn’t always react to them in the same way. Short-term rates—which are driven by the Federal Reserve—have been kept as low as ever and for longer than ever before. With the Fed poised to raise them, some fear that market carnage will ensue. Whether investors believe the Fed is acting too quickly, too slowly, or perhaps not enough can make all the difference. That’s the message of the accompanying charts, one from a period of Fed moves in the 2000 s and another from the mid- 1990 s. During the former, the Fed raised short-term rates roughly 4 percentage points between March 2004 and June 2006 . Compared with some earlier cycles, the reaction was measured. Yields for 10 - and 30 -year Treasuries didn’t rise anywhere near as much as short-term rates did (as the first chart shows, leading to a “flatter” yield curve), and the 10 -year bond lost 1 . 7% , while the 30 -year bond actually gained 2 . 2% .

8.0

6.9

5.8

p 12/30/94 p 09/30/94 p 06/30/94 p 03/31/94 p 12/31/93 p 09/30/93

4.7

3.6

3 M

6 M

2 Y

3 Y

5 Y

10 Y

30 Y

Maturity

That makes it extra tricky to predict how funds will fare when the Fed chooses to act. There are a few things we can say: p Some rate shifts, as those of 1994 , can be especially damaging to long-duration funds: The long-term bond Morningstar Category tumbled 6 . 8% that year. Its results during the March 2004 to June 2006 stretch were much better ( 0 . 76% ), but both showings left the category near the very bottom of the fund universe. p The flip side is that short-duration funds almost always perform better than others during rising-rate periods, but the range can be wide from one rate cycle to another, especially depending on how fast the Fed chooses to move. p If the economy is healthy or gaining strength, you can usually expect credit-sensitive funds to perform better than higher-quality, longer-maturity fare. The wild card this time is that, to attract investors while rates have been low, many loans promised a minimum level of income regardless of how low short-term rates got. When short rates rise, though, that means many loans won’t see their own rates float up until short rates get above those floors. K Contact Eric Jacobson at eric.jacobson@morningstar.com p Normally the last two items make bank-loan funds— which hold floating-rate junky loans—star players.

Fed Funds Hikes: How the Market Responded in the Mid-2000s

Yield (%)

5.5

p 06/30/06 p 03/31/06 p 12/30/05 p 09/30/05 p 06/30/05 p 03/31/05 p 12/31/04 p 09/30/04 p 06/30/04 p 03/31/04

4.5

3.5

2.5

1.5

3 M

6 M

2 Y

3 Y

5 Y

10 Y

30 Y

Maturity

Yet, things can get much worse. Rate cycles rarely occur with the same speed, magnitude, or length, and when the Fed acted in 1994 , investors pushed up longer-term bond yields in tighter step with the