Interest rates have been low for more than five years. The economy seems to be gaining momentum, and inflation is edging up. The Fed is buying fewer long-term bonds every month and eyeing a possible short-term rate hike next year. To many people, the conclusion is obvious: Interest rates are sure to rise a lot, and soon.
Not so fast, say Fidelity's Julian Potenza, fixed income asset allocation analyst, and George Fischer, managing director of research. "We think many investors are being overconfident about their ability to predict rate moves," says Fischer. "No one knows the future."
That perspective has important investment implications. Potenza and Fischer argue that the inherent uncertainty of markets calls for maintaining a strategic position in bonds, with a mix that suits your specific situation and reflects the reasons you hold fixed income.
Potenza and Fischer present three potential scenarios for future rate moves:
Scenario #1: Rates stay below “normal” levels but bump up slowly and unevenly.
Fischer and Potenza think this is the most likely outcome for the bond market over the next two to three years. For rates to rise a great deal, the economy almost certainly would have to strengthen meaningfully—and while the economy continues to heal, it remains shaky in important ways, particularly GDP growth, wage growth and workforce participation.
A slew of other factors, from the aging population to low global inflation to Fed caution, also support the thesis of a very gradually healing economy and a slow, bumpy rise in interest rates.
The market appears to have priced in a gradual rate increase, say Potenza and Fischer. In this scenario, bond prices should decrease modestly, with longer-term bonds’ prices falling more than the prices on shorter-term bonds. Meanwhile the higher yields on longer-term bonds should help to offset their larger price declines. The result: Bonds across the yield curve could be expected to produce roughly flat total returns while providing important tail risk protection during periods of market volatility.
Scenario #2: Rates jump.
Interest rates could leap upward and result in substantial losses for bonds, especially on the long end. A sharp rise in rates might result from a surge in economic growth or a rapid increase in inflation. In either case, the Fed may raise short-term rates sooner than expected.
Potenza and Fischer say that that future seems unlikely, but they don’t rule it out. If rates spiked, bond prices would fall substantially and investors’ total returns would suffer, at least in the short term. The impact wouldn’t be entirely negative for investors with long time horizons, however, because they’d be able to reinvest the principal from maturing bonds at higher yields. At the same time, an accelerating economy might make a positive backdrop for corporate earnings, which in turn could help the performance of stocks. So a diversified portfolio might benefit from strong stock returns even as bond prices fell.
Scenario #3: Rates stay low or fall.
Rates could stay put or decline for a number of reasons. A geopolitical crisis could shake the global economy—the likelihood of such an event occurring seems to have increased recently. The U.S. economy could slow, perhaps as the result of weakness in Europe or Asia. The Fed could decide that the economy needs additional stimulus, leading it to retreat or reverse course on its plan to reduce its bond purchases.
In this scenario, bonds are likely to be one of very few asset classes that perform well.
Implications for investors
When considering how to invest your fixed income portfolio, start with the reasons you hold bonds. The objectives for your bond allocation will largely determine the mix of security types and durations that are right for you.
The bottom line
It may be natural to expect rates to return to levels that have long been considered average—say 4%–5% on the 10-year Treasury. But a lot has happened since rates were that high, including the global financial crisis and the sluggish recovery. Economic conditions suggest that rates might persist at historically low levels even if they do drift somewhat higher over the coming years.
More fundamentally, rate forecasting has proven challenging even for professional investors. Rather than
trying to time the market and gamble on a rise in rates, the best strategy may be to align your bond holdings with your longer-term investment goals.
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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 these investments by making them available to its customers.
Views expressed are as of August 15, 2014, and may change based on market or other conditions. The opinions provided are those of the speakers and not necessarily those of Fidelity Investments. As with all your investments through Fidelity, you must make your own determination as to whether an investment in any particular security or securities is consistent with your investment objectives, risk tolerance, financial situation, and evaluation of the security. Consult your tax or financial adviser for information concerning your specific situation.
Neither diversification nor asset allocation ensures a profit or guarantees against loss. 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 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. Lower-quality debt securities involve greater risk of default or price changes due to potential changes in the credit quality of the issuer.
*Defined maturity funds are not designed for investors seeking a stable net value asset (NAV) or guaranteed income. The municipal market is volatile and can be significantly affected by adverse tax, legislative, or political changes, and by the financial condition of the issuers of municipal securities. To protect existing shareholders and to ensure orderly liquidation of the funds, the funds will close to purchases for new and existing shareholders 12 months prior to their maturity date. Asthe funds approach their liquidation dates, the fund's securities will mature and the funds may reinvest the proceeds in money market securities with lower yields than the securities previously held by the funds. Although money market funds seek to maintain a stable NAV of $1 per share, this is not guaranteed, and they may in fact lose money. In addition, the amount of the fund's income distributions will vary over time, and the breakdown of returns between fund distributions and liquidation proceeds will not be predictable at the time of your investment, resulting in a gain or loss for tax purposes. A portion of fund distributions may be subject to state or federal income taxes or to alternative minimum taxes, or be taxable as capital gains.
Any fixed income security sold or redeemed prior to maturity may be subject to a substantial gain or loss. Increases in real interest rates can cause the price of inflation-protected debt securities to decrease.
Interest income generated by Treasury bonds and certain securities issued by U.S. territories, possessions, agencies, or instrumentalities is generally exempt from state income tax but is generally subject to federal income and alternative minimum taxes and may be subject to state alternative minimum taxes.
Foreign securities are subject to interest rate, currency exchange rate, economic, and political risks, all of which are magnified in emerging markets. These risks are particularly significant for funds that focus on a single country or region.
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