Don’t Fear this Fed
By Kyle Tetting
In February 1994, the Federal Reserve began tightening monetary policy. Under Fed Chairman Alan Greenspan, the Fed raised the overnight lending rate to 6% from 3% in the span of a year. In that time, bonds suffered their worst losses of the past 25 years. The Barclays Intermediate Credit Index – a proxy for the kinds of bonds a typical fund might invest in – lost 2.5%. Even the best-run bond funds saw declines of 1%-2%.
Near record lows, today’s interest rates should return to a more neutral level over the next few years. Analysts expect the overnight rate to return to around 2.5% from a current range of 0.25%-0.50%.
While rate increases from the Fed seem likely, there are reasons for investors to believe that this time will be different than 1994.
For one thing, in 1994, Greenspan was concerned about potential inflationary pressure. Today, the Fed is intent on restoring rates closer to a normal level amid anemic inflation.
Also, unlike 1994, today’s Fed has done a better job of communicating the timing and magnitude of its intentions. Current Fed Chair Janet Yellen said throughout 2015 that the Fed would raise rates, which it finally committed to at its final meeting of the year. Since then, Yellen has indicated that the Fed remains focused on holding rates steady as employment improves and inflation remains muted.
In declining to raise the overnight rate Nov. 2, the Federal Open Market Committee set the stage for a potential increase as early as Dec. 13 or 14, when it meets again.
“The Committee judges that the case for an increase in the federal funds rate has continued to strengthen but decided, for the time being, to wait for some further evidence of continued progress toward its objectives,” the Fed said in a statement.
Managing expectations appears key to this round of tightening, reminiscent of a two-year stretch that started in June 2004. Following a more successful effort to raise rates gradually from 1999 to 2000, the 2004 Fed orchestrated an increase to 5.25% from 1% in a two-year span. Unlike the 1994 move, the 2004 Fed progressed slowly, moving just one-quarter of a percentage point (0.25) per meeting.
Through consistent moves and clear communication, markets remained calm in 2004, and bonds held their own. In the two years that coincided with the 2004 Fed tightening, the Barclays Intermediate Credit Index gained 5.4%.
Rising Interest Rates Don’t Always Mean Losses
|Overnight Lending Rate Increase||Barclays U.S. Intermediate Credit Index Total Return|
|Feb. 1994 – Feb. 1995||3 percentage points||-2.5%|
|June 1999 – May 2000||1.75 percentage points||1.4%|
|June 2004 – June 2006||4.25 percentage points||5.4%|
Bond investors learned an important lesson in 2004. While bond prices move inversely to interest rates, and investors’ bond prices fell, spreading out the rate increases allowed the bond interest to keep investors in the green.
Net-Net – or including the change in the price of bonds plus the interest received – the total return on most bond funds saw positive returns, a contrast to 1994.
Net-Net: The change in the price of a bond fund plus any interest
One other consideration when looking at potential rate increases: Returns in bonds are largely tied to interest rates. So, a rising-rate environment allows investors to replace lower-yielding bonds as they mature with higher-yielding bonds. Especially in short-term bond funds, such turnover can help offset any price decline and provide better potential returns from the higher-yielding bonds.
Without meaningful inflation, it appears likely that the Fed now can proceed with rate increases at an unhurried pace. Nevertheless, the potential increase in the overnight lending rate looms, forcing us as investors to remember why we hold bonds. An appropriate allocation to bonds provides diversification, more stable return and a key source of income during periods of stock market volatility.
Even at their worst, bonds hold up much better than stocks. Consider 1994, when intermediate corporate bonds lost a little more than 2.5%. In 2008, a rough year for stocks, the S&P 500 declined 37%. And, importantly, stocks and bonds rarely trade lower at the same time.
A small amount of pain may accompany a move to higher rates, but with the right investments, bond investors should weather the storm and emerge in a much better place.
Kyle Tetting is research director and an investment advisor at Landaas & Company.
(initially posted Nov. 3, 2016)