(PUB) Investing 2015

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When the Fed Raises Rates Income Strategist | Cara Esser

when rates rise. Bank loans do have less interest-rate risk than many other types of bonds, but there’s still credit risk. Furthermore, bank loans may act more like short-duration, fixed-coupon bonds than floating-rate securities when rates first rise because of Libor floors. This sets a minimum payment if the reference rate (Libor) falls below the specified “floor.” With rates currently below most Libor floors, bank-loan coupons may not rise with the Fed’s first interest-rate hikes. Global-Bond Funds It’s generally expected that the eurozone and Japan will rely on quantitative easing much longer than the United States, delaying rate hikes overseas. But the market for high-quality non-U.S. government bonds can track U.S. Treasuries when investors seek safe-haven assets. If the Fed delays the hike, it may stoke fears of slowing global growth, and those bonds could strengthen. And the dollar is likely to weaken, which would boost issues denominated in euros or yen. Emerging-markets bonds face big challenges, as those currencies have weakened against the dollar, making debt loads more expensive. Further delays in U.S. rate hikes may cause even more damage as investors continue to flee. Local-currency emerging-markets bonds, which have already been hit harder than bonds denominated in U.S. dollars, are likely to suffer more as investors dump riskier fare. Municipal-Bond Funds Municipal bonds, like corporate and government bonds, are issued with a range of maturities, so dura- tion dynamics are at play here. Importantly, muni bonds are tax-advantaged, providing an additional cushion during periods of rising rates. As interest rates rise, the income component of a bond’s returns helps buoy its total return as the bond’s price drops—the higher the payout, the more it counters a share price decline. The supply/demand story for munis may also provide a boost. Muni bonds’ tax- equivalent yields are high and in demand, and, as interest rates rise, issuers are less likely to refinance existing bonds, which may reduce the supply. K Contact Cara Esser at cara.esser@morningstar.com

Bond investors continue to fret about the potential timing and magnitude of interest-rate hikes from the Federal Reserve. The general consensus coming into 2015 was for liftoff in June, but weaker- than-expected economic data shifted expectations to a later rate hike. At its September meeting, the Fed kept rates unchanged and, once rates lift off, many expect a very gradual move toward normal- ized interest rates. While it’s difficult to predict how funds will fare in the face of rising rates, certain Morningstar Categories of funds are likely to do better than others. Core Bond Funds Morningstar categorizes core bond funds by duration— short, intermediate, and long term. The Fed doesn’t control the intermediate and long ends of the yield curve, however, and markets have responded differ- ently in past rounds of rate hikes. For example, during the hikes from March 2004 to June 2006 , the yield curve significantly flattened; during the September 1993 to December 1994 hikes, the yield curve shifted in a virtually parallel fashion. If the yield curve steepens or shifts upward in a more or less parallel fashion, long-term bond funds will underperform short-term bond funds, perhaps significantly. But if the yield curve flattens, which is not out of the question given the troubles abroad that may continue to push investors toward the safe haven of U.S. Treasury bonds of all maturities, shorter-term bond funds may not provide as much of a cushion against rising rates. Corporate-Credit Bond Funds Because the economy is healthy, credit-sensitive funds should perform better than funds that hold higher- quality, longer-maturity bonds. These are funds in the corporate, high-yield, and bank-loan categories. Many investors have turned to bank loans, assuming that floating-rate bank-loan coupons will rise