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A reset for the bond markets

Yields spiked and prices went down, making it a good time to know what you own.

  • By Roger Young, Senior Vice President of Fixed Income, Fidelity Capital Markets,
  • Fidelity Viewpoints
  • – 06/27/2013
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About the expert

Roger Young
Roger Young is responsible for managing Fidelity Capital Markets' fixed income support functions for the retail, correspondent banking, and precious metals trading units. He is a 30-year financial services veteran with extensive experience in institutional banking, portfolio management, trading, and research in the U.S. debt markets.

It may be time for bond investors to reset their expectations. The past month has been one of change for the bond market. Early in the month, bonds experienced the biggest one-month rise in rates since March 2012. Then came a bout of selling after the June 19 Fed meeting, which pushed rates even higher, and pushed the value of bonds down.

Viewpoints checked in with Roger Young, senior vice president in Fidelity’s Capital Markets fixed income division, about recent developments in the bond market and implications for investors.

What happened to the bond market after the Fed meeting?

Young: A few key parts of the Fed’s statement on June 19 suggested that it may be getting ready to end its program of bond buying. That was enough to cause the second major bout of selling in the bond market this year. The Barclays U.S. Aggregate Bond Index, a diversified bond index, which was still positive in May, is now down 2.9% year to date. The impact has been more pronounced on 10-year securities and longer-dated funds, which are more sensitive to rates and have posted 9%–10% negative returns year to date.

What is surprising is how quickly rates have changed in recent weeks. The 10-year Treasury yield rose from 1.60% on April 26 to 2.53% on June 26, surpassing the high yields reached in the spring of 2012, and the mid-range yields of 2011.

Liquidity and leverage also are contributing to this. Recent New York Fed data shows that inventories of corporate bonds among the large banks has shrunk dramatically, from $200 billion at their 2007 peak, to just over $50 billion. This is due in part to the ban on banks’ proprietary trading instituted by Dodd-Frank, the post-crisis financial-reform law. Global markets have been impacted as well. Emerging markets have recently experienced a large increase in rates, and many sovereign issues have been unable to come to market or have had failed auctions. In developed countries, problems still exist in parts of Europe, which continue to face continued economic challenges.

Did anything change in the Fed outlook?

Young: The notes from the June 18–19 Federal Reserve Bank’s Open Market Committee (FOMC) meeting didn’t give the impression that the Fed is abandoning its policy of extraordinary accommodative monetary policy through ultra-low short term interest rates and quantitative easing. The Fed’s overall assessment was modest improvement. However, a sentence in the FOMC statement that “downside risks to the outlook and the labor market have diminished,” along with the committee’s view that lower inflation is due to “transitory factors,” seemed to be a signal to many that a tapering of bond buying by the Fed would start sooner rather than later, and that was the catalyst the market reacted to.

So, the market seemed to have a very quick change in the perception that there was “no set target date” after the third round of QE in the fall of 2012 (dubbed by many as “QE infinity”) to, suddenly, “QE ending.” After the Fed meeting, at least 44% of economists polled by Bloomberg felt the Fed will taper purchases by September of this year and 59% felt the Fed would wind down the program entirely by June or July of 2014. That’s an interesting perspective, given that the Fed has reaffirmed its QE and said it won't raise short-term rates before unemployment drops to 6.5%, which it doesn’t expect to happen until 2015.

What does it all mean for investors?

Young: I think investors should keep several things in mind.

No. 1: The Fed is not tightening yet and the market is trying to “normalize” the interest rate environment, given less Fed buying through QE.

No. 2: While the economy has improved—consumer sentiment, housing, and other areas of the economy are at post-recovery highs—GDP came in at a revised 1.8%, down from 2.4%. Fed Chairman Ben Bernanke said reducing bond purchases would depend on the economy growing in line with the central bank’s projections. Policymakers are forecasting growth of as much as 2.6% this year and 3.5 % next year.

No. 3: A lot of money has been invested in bonds since 2009, almost $1 trillion according to TrimTabs Investment Research,—a record—so the outflows may be due to those who are overallocated or worried about losses as rates rise. And while it is not unusual to see rates rise well before the Fed removes accommodative policies, many sub–asset classes, such as longer-dated munis, at 5%, are starting to look more attractive. On a historical basis, yields on longer-dated munis are well above the yields of Treasuries—even taking into account the tax-free income—and rates are close to their longer term averages.

No. 4: Eventually, higher rates can have a negative impact on the market. For example, mortgage rates—e.g., 30-year conventionals—are now at 4.5%, up from 3.5% in April. This could have an impact on home affordability and affect the housing recovery.

No. 5: A 100-basis-point move (one percentage point) in the bond markets is not uncommon—it’s happened two times prior to this move in the post-2008 Great Recession. In 2009, rates went from 2.30% to 3.80% in six months. In 2010, 10-year yields went from 2.30% to 3.60% in five months. What is unusual is to see this happen in two months. That said, we are settling in at 2.60% on 10-year Treasury yields, and the average on yields for this maturity since January 2008 is 2.84%. Thus, maybe we are close to a level that is more consistent with where interest rates should be, given current fundamentals in the economy and inflation, and an eventual easing of the Fed’s loose monetary policy.

What about investors whose bonds lost value?

Young: Bond investors need to think about the purpose of fixed income in their portfolios. Some people just want income from individual securities like municipal bonds, and these price movements from month to month may not bother them. Other people may be in a variety of mutual funds, some of which give broader diversification and lower exposure to rate movements. Now is a great time to review your portfolio to see what kinds of bonds you own, and to see the duration mix and the level of diversification in different types of bonds.

Volatility will probably be here to stay. If you are uncomfortable with it, consider diversifying and shortening duration. Or, if you think rates are going to rise more dramatically, consider bonds that adjust to rates, like floating-rate issues.

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The information presented above reflects the opinions of Roger Young as of June 26, 2013. These opinions do not necessarily represent the views of Fidelity or any other person in the Fidelity organization and are subject to change at any time based on market or other conditions. Fidelity disclaims any responsibility to update such views. These views may not be relied on as investment advice and, because investment decisions for a Fidelity fund are based on numerous factors, may not be relied on as an indication of trading intent on behalf of any Fidelity fund.
Past performance is no guarantee of future results.
Diversification and asset allocation do not ensure a profit or guarantee against a loss.
As with all your investments through Fidelity, you must make your own determination whether an investment in any particular security or securities is consistent with your investment objectives, risk tolerance, financial situation, and evaluation of the security. Fidelity is not recommending or endorsing this investment by making it available to its customers.
In general, the bond market is volatile, and fixed income securities carry interest rate risk. (As interest rates rise, bond prices usually fall, and vice versa. This effect is usually more pronounced for longer-term securities.) Fixed income securities also carry inflation risk, liquidity risk, call risk, and credit and default risks for both issuers and counterparties. Unlike individual bonds, most bond funds do not have a maturity date, so holding them until maturity to avoid losses caused by price volatility is not possible.
The Barclays U.S. Aggregate Bond Index measures the performance of investment-grade bonds traded in the United States.
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