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Rising Rates & Core Bond Funds: Possible Scenarios, Positive Outlook

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As the magazine goes to print, the markets await news from the Federal Open Market Committee. Many fund managers, Fed watchers and economists are expecting a rate hike, the first since June 2006, given that we’ve experienced “the longest stretch in history that the so-called Fed policy rate has gone without a change,” according to Eric Jacobson of Morningstar.

While it is hard to predict how the markets will react if a rate hike in December is followed by more hikes over the coming months (and years), there is some history to review, Jacobson says. The Fed rate hikes that began in early 1994, for instance, included seven hikes of different amounts that brought the target Fed-funds rate up by a total of 300 basis points in 12 months.

Though there were some “outlier” portfolios that got hit by huge losses, the intermediate-term government-bond Morningstar category did not experience such trauma. In fact, four of the five Morningstar Medalists in the category, Jacobson points out, even performed better than the average.

“There was short-term pain over the period of the Fed’s hikes, but it didn’t take long for investors to recoup those losses. And, if anything, that helps support the notion that quick, sharp, short-term rate hikes, in and of themselves, aren’t necessarily the disaster for longer-maturity bonds that they might appear to be,” explained the senior analyst, who covers active strategies for Morningstar’s manager research team.

In 1993, the intermediate-term bond category had some $39 billion in assets. It now has over $1 trillion. The intermediate-term government group, though, remains limited — at roughly one-tenth that size.

From June 2004 through June 2006, the FOMC raised the Fed-funds rate 17 times, for a total of 425 basis points. During this stretch, the average intermediate-term bond fund “still managed a total return of more than 5.6%,” Jacobson explained in a recent online article. Looking back at the three major rising-rate cycles since 1993, the financial crisis “was a much bigger problem for most of them,” he adds.

Reasons for Optimism?

Fed watchers predict gradual hikes of 25 basis points at a time, which could be stretched over many months between hikes. Plus, the Treasury market has “relatively muted expectations” as do many fund managers when it comes to future levels of inflation, Jacobson notes.

Prices for Treasury Inflation-Protected Securities, for instance, seem to be anticipating 1.3%-per-year level of inflation over the next five years and 1.6% for the next decade. It is difficult to see them “coming close to the 3.1% pace of inflation (as measured by the Consumer Price Index) observed, on average, from 2004 through 2006,” he says.

Forward Treasury bond curves appear to be predicting that the 10-year note may yield 30 basis points more a year from now than it does today, 50 basis points more in two years, and 70 basis points more in three years, according to Jacobson: “Those numbers aren’t negligible, but, spread over enough time, that level of change in the yield for a 10-year Treasury bond implies a much less bumpy ride than many investors seem to fear.”


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