Bond Insight: Is 2013 The Year Interest Rates Rise?

Schwab Bond Insights: Is 2013 the year that rates rise?

January 18, 2013

by Kathy A. Jones, Vice President, Fixed Income Strategist, Schwab Center for Financial Research,
and Rob Williams, Director of Income Planning, Schwab Center for Financial Research,
and Collin Martin, Senior Research Analyst, Fixed Income and Income Planning, Schwab Center for Financial Research

The Schwab Center for Financial Research (SCFR) presents Bond Insights, a bi-weekly analysis of the top stories in today's bond markets. This issue discusses investing in a low yield environment with the risk of rising rates on the horizon, Q4 2012 sector performance numbers, an outlook on the municipal market and a discussion on Treasury Inflation-Protected Securities (TIPS).

Is 2013 the year that rates rise?

The new year started with a jump in long-term interest rates, a trend we've seen many times in the past. In thirteen of the past sixteen years, ten-year Treasury yields have peaked in the first half, and subsequently declined later in the year. Recently, the yield on the ten-year Treasury hit its highest level since last May and about 50 basis points off the all-time low of 1.39% set in July 2012. Optimism about improving economic growth and the possibility that the Fed will reduce or end its bond buying program this year have been contributing factors to the rise in rates. Since yields are on the rise, talk of the bursting of the "bond bubble" has heated up – again. While we don't anticipate a big increase in interest rates this year, there is little room for rates to move down. And we've seen how skittish the market can be just with a hint of a change in policy. What should investors consider doing with yields low and the risk of rising rates on the horizon?

Ten-Year Yields: 1997 to 2013

Source: Bloomberg. 10-Year Treasury Yield (USGG10Y), Percent, Daily, Not Seasonally Adjusted. Data as of January 15, 2013. Alternate shading indicates the beginning and ending of each year.

• Our interest rate outlook does not call for a significant rate increase this year or a change in Federal Reserve policy. In our view, the pace of economic growth is likely to remain sluggish due to ongoing de-leveraging and weak income growth in the consumer sector, along with headwinds from tighter fiscal policy domestically and the recession in Europe. However, with yields so low in the fixed income markets, the risks in long-term bonds are rising. Even a small increase in rates could send bond and bond fund prices lower, causing investors who sell to incur losses.

• Low coupons and long duration¹ are the greatest potential risks. Even though we don't expect an imminent rise in rates, we believe investors need to examine their bond and bond fund holdings closely—before rates rise. Prices of long duration bonds, especially those with low coupons, are likely to fall when rates move up. This leaves investors with the decision of whether to hold to maturity, ignoring the price drop, or to sell (potentially at a loss) and look to reinvest the remaining principal at higher rates.

• Compared to bond funds, an advantage to holding individual bonds is that, barring default, buy and hold investors are able to get principal returned to them at par if they hold to maturity. And if they purchased bonds several years ago, there's a good chance that the coupon payments on the bonds are higher than what they might get in the prevailing market where rates are moving up slowly. On the downside however, an investor owning individual bonds might miss out on the potential to reinvest their principal at higher rates, and it is harder to achieve broad diversification in a portfolio of individual bonds than with a fund.

• For bond fund investors, there are many factors to weigh, in part because there are so many types of bond funds with many different strategies. Funds that use leverage, particularly closed-end funds that borrow in the short-term interest rate market, are susceptible to significant declines if rates move up quickly. Moreover, funds that are less liquid may experience outflows due to investor redemptions, forcing the fund manager to sell assets into a weak market. However, the potential advantages of bond funds, such as professional management and diversification, may mean that it makes sense for some investors to continue to hold a fund even in a rising rate environment. Some fund managers may be able to reinvest at higher rates, increasing the income the fund distributes to investors. There are even funds that can use derivatives to deliver negative duration² in their funds, seeking to take advantage of an increase in rates.

• A warning for investors tempted to move out of bonds entirely, replacing them with other investments—we would warn that changing your asset allocation based on an expected change in interest rates could actually increase volatility and risk. Bonds continue to be an important part of overall asset allocation, providing diversification from equities and other asset classes. Also, individual bonds have a fixed maturity date and anticipated return. For those tempted to sell their bonds and sit on the sidelines in cash, there are risks as well. If interest rates don't rise significantly, then the inability to earn higher income may alter your investment plan or lead you into riskier investments later on. Timing the market is always difficult.

• Bottom line. 2013 may be the year that the long-term downtrend in interest rates ends, but we believe investors should position their portfolios to deal with a range of possibilities. We advise investors to take this time to look at the maturities and durations of the bonds and bond funds that they hold now to prepare for the possibility of higher rates down the road.

Q4 2012 Sector Performance
Corporate and emerging market bonds paced the fixed income markets in Q4 2012, as many investors continued to search for higher yields than those available in U.S. Treasuries. Central banks, domestically and abroad, maintained easy monetary policies, keeping short-term interest rates at historically low levels. The additional yield available in riskier sectors of the market helped support bond prices, in our opinion. However, with yields low and prices high, we think that returns going forward are unlikely to be as strong as over the past few years.

• U.S. Treasuries generated mostly negative returns. U.S. Treasury yields ended the quarter higher than where they started, leading to lower prices. For the year, however, The Barclays U.S. Treasury Bond Index did generate a total return of 2%. In December, the Federal Reserve announced a continuation of their near-zero interest rate policy, and indicated that future rate hikes will be conditional on the unemployment and inflation rates rather than targeting a date range. The Fed also announced it would continue open-ended Treasury purchases to the tune of $45 billion per month. We think these two factors will keep Treasury yields from rising significantly anytime soon, but investors should be prepared for higher yields in the future. Long-term Treasury yields at or below the rate of inflation offer very little benefit beyond diversification, in our view.
• Investment grade corporate bonds outperformed the Treasury market. The investment grade corporate bond market continues to be supported by investors searching for higher yields, in our opinion. For the year, the Barclays U.S. Corporate Bond Index generated a total return of 9.8%, marking the fourth straight year of total return above 8%. For the quarter, the sectors perceived to be the riskiest outperformed their higher-quality counterparts. Triple "B" rated bonds and bonds issued by financial institutions generated the highest returns in the investment grade realm. But yields remain near their all-time lows, meaning there may be less room for yields to drop, limiting the upside price potential. We continue to favor intermediate-term investment grade corporate bonds, and we think that coupon income will be a main driver of performance going forward, not price appreciation.

4Q 2012 Sector Performance

Source: Barclays, as of December 31, 2012. Shown above are total returns for corresponding Barclays indices. Past performance is not indicative of future results.

• High yield bonds had the highest total returns in the U.S. fixed income markets. The Barclays U.S. Corporate High Yield Bond Index outperformed all domestic sectors of the fixed income markets for the quarter, with a total return of 3.29%. For the year 2012 the high yield index posted an annual total return of 15.8%. The average yield of the index dropped during the fourth quarter, pushing up the average price of the index to its all-time high. Like the investment grade market, we think that coupon income may be the main driver for performance for the coming year. With yields near all-time lows, we believe the risk/reward for sub-investment grade (high yield) bonds is becoming less attractive. We suggest short maturities for most investors considering these bonds, preferably four years or less. Investors may also want to consider exchange-traded funds (ETFs) or mutual finds that target short maturity ranges as well.

• Currency fluctuations affected the international bond markets. Lower yields in both developed and emerging markets pushed bond prices higher in the fourth quarter, but not all sectors of the international bond market experienced positive returns. The Barclays Global Aggregate ex-USD Bond Index contains an allocation to Japanese yen-denominated bonds. The yen weakened against the dollar and lowered returns for U.S. investors. The Barclays Global Emerging Markets Index, on the other hand, only contains bonds denominated in the U.S. dollar, the euro and the British pound. The euro and the pound strengthened against the dollar, helping generate stronger returns for the index. We expect developed market bond yields to remain low as central banks continue with their accommodative policies, and emerging market bonds may continue to benefit as investors look to lower-rated sectors to try and pick up additional yield.

Muni Outlook

Muni markets worked through a rough patch in late December driven by a number of factors—concerns about the debt ceiling, debate about taxes including possible reduction in deductions and exemptions, a downgrade to Puerto Rico, and limited liquidity and trading into year-end. For the year, though, it was another year of positive returns driven by price appreciation more than income. We've said it previously, but we'll repeat again—we don't count on continued price-driven returns in high-quality munis given the low level of interest rates. Prices rise as rates fall, all else being equal.

• Weakness in December… a blip on the screen or sign of more to come? The broad Barclays Municipal Bond Index lost 1.24% on a total return basis in December, the worst month of the year, bouncing back in early January. All of the factors noted above were at play, most importantly (in our view) concern about the muni tax-exemption in the fiscal cliff debate and a very slow market moving into year end.

• Longer-maturity and high-yield muni bonds outperformed shorter-maturity and highly-rated munis for the year. The hunt for yield continued, as investors looking for income drove strong price driven returns. The Barclays Long Bond (22+) Muni Bond Index delivered a 11.3% total return for the year, outpaced by an 18.1% total return in the Barclays Muni High Yield (sub-investment grade) Index. States with higher credit risk, such as California (8.1% total return for the Barclays CA state-specific index) and Illinois (8.1%), generated higher total returns than the broad Barclays Municipal Bond Index at 6.8%.

Long-term Bonds Outperformed as Rates Fell

Source: Barclays Municipal Bond Indices. Yield to worst as of December 31, 2011.Total return for 2012.

• Risk rises as yields fall. The trend of outperformance of longer maturity bonds and those with higher credit risk continued, highlighting the appetite for income wherever it can be found. The conundrum is what are investors to do about it? In our view, the risk-reward balance becomes increasingly out of balance the farther yields fall, especially in longer-maturity bonds over 10-12 years as the muni yield curve has flattened (shown in the chart above). While rates may not increase significantly soon, price sensitive investors might consider looking for opportunities to take gains.

• We continue to favor credit over interest rate risk. We don't expect a repeat of the performance in the high-yield muni sector in 2013, though a modest step down in quality from the AAA-AA range may make sense for investors looking to add yield to a muni portfolio currently biased toward quality. We continue to favor highly-rated general obligation and essential service revenue bonds (water/sewer) etc, but yield in these areas continues to be tough to come by. Although defaults and distress in bonds rated investment-grade and higher have been widely publicized, they remain a small part of the muni market. Defaults and bankruptcies also fell in 2012 relative to 2011, a trend that we expect to continue.

• Much to the relief of the market, the muni-tax exemption so far has survived the fiscal cliff unscathed. In fact, the tax increases approved as part of the fiscal cliff legislation are supportive of muni bonds. Here are the recent, relevant changes to tax law:

• Marginal income tax rate. Increases to 39.6% for singles earning $400,000 and up and $450,000 for those married filing jointly.

• Capital gains and qualified dividends. Increases to 20% for individuals in these same tax brackets.

• Medicare investment income tax. The Medicare tax was increased on net investment income to 3.8% for singles earning $200,000 and up and $250,000 for those married filing jointly. This new tax was part of the Affordable Care Act (ACA) passed earlier in 2012, not the fiscal cliff legislation. It does not include tax-exempt municipal bond interest in the definition of net investment income.

We think all of these factors could support demand for tax-advantaged income.

• The tax-exemption isn't completely off the table. The debate about revenue isn't going to disappear as the debate turns to spending. The Administration has continued to support a plan to place a blanket cap on all deductions and exemptions. It's an issue investors may want to watch, as we will, though any change remains only speculation. We do not recommend a change in strategy based on the tax-exemption.

• Bottom line. For all areas of the bond market, the lower yields go, the greater the risk to price-sensitive investors if they begin to rise. In 2013, we expect to see greater rate-driven volatility at times in the muni market and continue to favor credit risk over maturities longer than 10-12 years for investors seeking income.

Tips for TIPS Investors
Over the past few years, inflation has been low but U.S. Treasury Inflation Protected Securities (TIPS) have been in demand. Yields on most TIPS have recently fallen into negative territory, even as inflation readings have been trending down. Investors appear willing to pay a high price to protect against future inflation. Given the high prices and negative yields, how should investors consider approaching the TIPS market today?

• Inflation protection is important. Current inflation trends seem benign, but over time inflation can erode the value of an investor's principal. TIPS can provide a way to help protect principal from inflation because they are indexed to the overall consumer price index (CPI). The principal value increases with inflation and decreases with deflation. At maturity, you receive either the adjusted principal or the par value, whichever is greater. Interest is paid twice a year at a fixed rate, and the interest rate is applied to the adjusted principal. Consequently, interest payments rise and fall with inflation as well.

• But don't overpay for it. Currently, yields on TIPS with maturities of less than 16 years are negative, reflecting elevated inflation expectations and demand for securities that provide principal protection. Buying TIPS with negative yields means an investor will need the rate of inflation to increase over time in order to break even on their investment. The break even rate for TIPS can be estimated by the difference between the yield on a TIPS and a Treasury security with a similar maturity. The breakeven represents what the inflation rate, as measured by the CPI, must average over the lifetime of the security in order to earn a higher return than a comparable Treasury security. When yields are negative, an investor needs a rise in inflation above the prevailing level up to the breakeven rate just to protect the par value of the security.

Ten-Year TIPS Have Negative Yields

Source: Bloomberg. U.S. Generic 10-Year TIPS (USGGT10Y) daily data as of January 14, 2013.

• There may be better entry points to invest in TIPS. The 10-year TIPS breakeven rate is currently above 2.5%, compared to the 20-year average of 2.0%. With current inflation running at 1.8% and the Fed targeting inflation in the 2% to 2.5% range, we believe TIPS are more reasonably priced when breakeven rates are closer to 2%.

• Recent inflation readings have been tame. Based on the CPI, the rate of inflation has been trending lower for over a year. Although there are some forces, such as higher commodity prices that could lead to rising inflation, we believe the continued weakness in the labor market should keep a lid on inflation for the time being. Over the long run, income growth and inflation are related. With unemployment still high at 7.8%, workers don't have a lot of leverage to negotiate higher wages and consequently income growth has been weak. Until the trend in wages picks up, we expect inflation pressures to remain subdued.

• And TIPS may not give you the protection you think you're getting. TIPS help protect against higher inflation, not higher interest rates. If interest rates rise for reasons other than higher inflation, TIPS prices will generally fall (like other Treasuries), without the benefits of inflation compensation in the form of a higher principal value. Also, with the short-term outlook for inflation fairly tame, shorter-maturity TIPS may not give investors the inflation hedge that they may be looking for.

• Bottom line. TIPS are one of the few fixed income investments that offer a promised real return that adjusts with inflation. However, in our view, TIPS appear expensive currently for those looking for a positive after-inflation return.

For other articles, please visit schwab.com/onbonds.

1. Duration indicates how price-sensitive a bond is to changes in interest rates. There are a number of ways to calculate duration; the term generally refers to effective duration, defined as the approximate percentage change in a bond's price that will result from a 100-basis-point change in its yield. Another calculation, expressed in years, measures how long it takes for the price of a bond to be repaid by its internal cash flows.

2. Negative duration is a situation in which the price of a bond or other debt security moves in the same direction of interest rates. That is, negative duration occurs when the bond prices go up along with interest rates and vice versa.

Important Disclosures

Investors should carefully consider information contained in the prospectus, including investment objectives, risks, charges and expenses. You can request a prospectus by calling Schwab at 800-435-4000. Please read the prospectus carefully before investing.

Investment returns will fluctuate and are subject to market volatility, so that an investor's shares, when redeemed or sold, may be worth more or less than their original cost. Unlike mutual funds, shares of ETFs are not individually redeemable directly with the ETF. Shares are bought and sold at market price, which may be higher or lower than the net asset value (NAV).

Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed income investments are subject to various other risks including changes in credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications and other factors.

Income from tax-free bonds may be subject to the Alternative Minimum Tax (AMT), and capital appreciation from discounted bonds may be subject to state or local taxes. Capital gains are not exempt from federal income tax.

"High-Yield" (sub-investment grade or "junk") bonds are lower rated securities and are subject to greater credit risk, default risk, and liquidity risk than investment grade bonds.

Treasury Inflation Protected Securities (TIPS) are inflation-linked securities issued by the US Government whose principal value is adjusted periodically in accordance with the rise and fall in the inflation rate. Thus, the dividend amount payable is also impacted by variations in the inflation rate, as it is based upon the principal value of the bond. It may fluctuate up or down. Repayment at maturity is guaranteed by the US Government and may be adjusted for inflation to become the greater of the original face amount at issuance or that face amount plus an adjustment for inflation.

This report is for informational purposes only and is not an offer, solicitation or recommendation that any particular investor should purchase or sell any particular security or pursue a particular investment strategy. The types of securities mentioned herein may not be suitable for everyone. Each investor needs to review a security transaction for his or her own particular situation.

All expressions of opinion are subject to change without notice in reaction to shifting market, economic or geopolitical conditions. We believe the information obtained from third-party sources to be reliable, but neither Schwab nor its affiliates guarantee its accuracy, timeliness, or completeness.

Diversification strategies do not assure a profit and do not protect against losses in declining markets.

Index returns are for illustrative purposes only and do not represent actual fund performance. Index returns do not reflect any management fees, transaction costs or expenses. Indexes are unmanaged. One cannot invest directly in an index. Past performance does not guarantee future results.

Barclays Global Aggregate Index provides a broad-based measure of the global investment-grade fixed-rate debt markets. The three majorcomponents of this index are the U.S. Aggregate, the Pan-European Aggregate, and the Asian-Pacific Aggregate Indices.

Global Aggregate Bond Index ex US excludes the U.S. Aggregate component.

Barclays Global Emerging Markets Index consists of the USD-denominated fixed- and floating-rate U.S. Emerging Markets Index and the fixed-rate Pan-European Emerging Markets Index, which is primarily made up of GBP- and EUR-denominated securities. The index includes emerging markets debt from the following regions: Americas, Europe, Asia, Middle East, and Africa. An emerging market is defined as any country that has a long-term foreign currency debt sovereign rating of Baa1/BBB+/BBB+ or below using the middle rating of Moody's, S&P, and Fitch.

Barclays Municipal Bond Index consists of a broad selection of investment- grade general obligation and revenue bonds of maturities ranging from one year to 30 years. It is an unmanaged index representative of the tax- exempt bond market.

Barclays High Yield Municipal Bond Index consists of municipal bonds rated Ba1 or lower or non-rated bonds using the middle rating of Moody's, S&P and Fitch.

Barclays US Aggregate Bond Index represents securities that are SEC-registered, taxable and dollar denominated. The index covers the US investment-grade fixed-rate bond market, with index components for government and corporate securities, mortgage pass-through securities and asset backed securities.

Barclays U.S. Corporate Bond Index covers the USD-denominated, investment grade, fixed-rate, taxable corporate and non-corporate bond markets. Securities are included if rated investment-grade (Baa3/BBB-/BBB-) or higher using the middle rating of Moody's, S&P, and Fitch.

Barclays U.S. Corporate High-Yield Index the covers the USD-denominated, non-investment grade, fixed-rate, taxable corporate bond market. Securities are classified as high-yield if the middle rating of Moody's, Fitch, and S&P is Ba1/BB+/BB+ or below.

Barclays U.S. Treasury Bond Index includes public obligations of the U.S. Treasury excluding Treasury Bills and U.S. Treasury TIPS. The index rolls up to the U.S. Aggregate. Securities have USD250 million minimum par amount outstanding and at least one year until final maturity. Subindices based on maturity are inclusive of lower bounds. Intermediate maturity bands include bonds with maturities of 1 to 9.9999 years. Long maturity bands include maturities 10 years and greater.

Barclays U.S. Treasury Inflation-Protected Securities (TIPS) Index is a market value-weighted index that tracks inflation-protected securities issued by the U.S. Treasury. To prevent the erosion of purchasing power, TIPS are indexed to the non-seasonally adjusted Consumer Price Index for All Urban Consumers, or the CPI-U (CPI).

The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.