What will happen if 1994's sudden burst in interest rates repeats itself?
That is the question being asked by industry overseers and by investors who want to protect their commitments to fixed-income investments after four years of historically low payouts.
That year, interest rates on 10-year Treasury notes were hiked more than two points to nearly 8%. This jump slashed more than $600 billion from the value of U.S. bonds at a time when total market size was $10.4 trillion.
In fact, the total return on long-term bonds was negative when President Bill Clinton lost control of both houses of Congress two decades ago, says Morningstar economist Francisco Torralba.
Skip forward to the present. The Federal Reserve and the European Central Bank this month said near-zero interest rates will remain in place, preventing or at least putting off the possibility of any similar shifts for probably two more years.
Eventually, the now-$38 trillion U.S. bond market will see rates slowly step upward, says Nuveen Asset Management Co-Head of Fixed Income Tony Rodriquez. It is a mystery whether a sudden jump in rates will occur and how big an impact on the value of bonds would result.
"We expect [interest rates] will remain pretty low over a two-year time horizon," Rodriquez said. "So we expect some modest upward pressure, but not enough that it will be a 1994 scenario with a very sharp rise in rates that really hurts fixed-income portfolios significantly."
Tough Times
The 1994 panic saw the Barclays Capital U.S. Aggregate Index, a U.S. bond benchmark, drop below 2.96% in its total rate of return during the year, Torralba said. But, in 1995, the index catapulted back to an 18.5% return.
A sharp increase in interest rates is not expected this time around. But a two-percent move would be dramatic. Over the past three years, interest rates were at their highest in 2011 when 10-year notes were situated just above 3%. But since then, policies have handcuffed rates near the two percent marker. As of May 7, long term Treasuries were yielding 1.8%.
Torralba notes that yields will not surpass 3% until unemployment begins to rise and the Federal Open Market Committee (FOMC) "starts giving hints that large-scale asset purchases will end in 2014."
At the money management arm of Chicago-based Nuveen Investments, credit markets, high yield bonds, investment-grade credit, asset-backed and emerging markets strategies are deemed very attractive.
"Investors out there nervous about a sharp rise in rates will be missing out on opportunities in the meantime," Rodriguez said in a phone interview.
The firm, which manages more than $50.2 billion in mutual funds, is recommending its High Income Bond Fund and its Strategic Income Fund, among others, because their investments are not linked to particular sectors of domestic or international economies and their high yields provide income protection.
Should rates on Treasuries increase, these funds are less connected to monetary policy measures, because they invest in foreign-issued, high-yield bonds in developed and emerging markets.
Over the past 12 months, Morningstar data shows that yields on Nuveen's High Income and Strategic Income funds have been around 7.29% and 4.08%, respectively.
Core Diversifier
For Francis Kinniry, Jr., a principal inVanguard's Investment Strategy Group, this low interest-rate period has proved to push investment markets in directions that have been predetermined despite the fourth biggest bull market in stock market history also taking place. On May 1, 2009, the Standard & Poor's 500, for instance, stood at 872.74. On May 1 of this year, it reached 1,597.55.
"There are very factual and concrete things that we know that low rates give us," Kinniry, Jr. said earlier this month. "What they factually give us are forward-looking returns that are going to be much lower'' than in the past.
The Valley Forge, Pa.-based company currently manages $2 trillion in mutual fund assets, which includes $245 billion in exchange-traded funds.
But despite expectations that bond returns will stay historically low, Vanguard is asking its clients to "stay the course," the 16-year firm veteran said.
"Bonds have a low-return expectation, but they have a real important role in the portfolio," commented Kinniry Jr. Bonds "truncate equity risk and really we don't see a second asset that does that as good as bonds."
In March, funds that invest in bank loans, short-term bonds, senior loans and high-yield bonds continued to be attractive, according to a Morningstar report. Over the period, both Vanguard and bond giant Pacific Investment Management Company (PIMCO) "continue to capture the vast majority of industry inflows," the April 17 research stated.
Over the past quarter, funds that invest in U.S. stocks attracted $21 billion in investor dollars, the best quarter since 2004.
"I think many people worry about the great rotation, but what we're seeing is a rotation out of cash into bonds and into equities," said Scott Mather, a managing director and head of global portfolio management at Newport Beach, Calif.-based PIMCO.
"It's basically people moving away from cash deposits and money markets because they realize this is not a normal environment when cash is costless."
Short-term bond funds saw inflows of about $5 billion during March. The PIMCO Low Duration Fund received $900 million in new investor dollars during the month.
As assets shift between various fund portfolios and exposures, the Federal Reserve continues its Quantitative Easing effort, which includes $40 billion in purchases of mortgage-backed securities and $45 billion in Treasury securities per month.
Mather said that QE effort doesn't scare away every bond investor, however.
"Prolonged periods of zero interest rates and QE don't necessarily push people out of bonds, they continue to push people into bonds at a lower yield [and into riskier assets]," he said. "The danger is at some point when the first major central bank reverses course that a lot of this unwinds."
This unwinding, according to the PIMCO portfolio manager, will not bring Treasuries back up to pre-QE rates, where the 10-year note hovered at a 2.4% return in December 2008. This is why the "1994 bond collapse cannot happen," Mather said.
