Intermediate-term, investment-grade bonds have enjoyed a reputation with many investors as the “risk free” component of their fixed income portfolios. Yet in one single week―the week ending Nov. 11, 2016 (the week of Donald Trump’s victory in the U.S. Presidential election), the median fund in Morningstar’s U.S. Intermediate-Term Bond category lost a staggering -1.54%. How can an entire fixed income category that only yields around 3% per year and is often considered to be “risk free” sustain a loss of -1.54% in a single week?
The answer of course is that intermediate-term, investment-grade bonds are definitely not “risk free.” They are usually credit risk free, but they are certainly not interest rate risk free as was clearly evident during that historic week in early November.
Interest rate risk is a very real risk for fixed income investors―just as real as credit risk. Interest rate risk can cause real losses either slowly over time, or abruptly like it did during election week, when yields on the 10-Year Treasury bond spiked 37 basis points from 1.78% to 2.15%. When interest rates rise, bond prices generally fall. The magnitude of the price decline relative to the rate move is approximated by a bond or fund’s duration. The greater a bond or fund’s duration, the greater its price volatility relative to interest rate moves. A shorthand rule of thumb is that a bond’s duration tells you the percentage loss it would incur given a 1% increase in rates. For example, a bond with a 5-year duration would be expected to lose approximately 5% if interest rates increased by 1%.
Rate Movement’s Impact on Sample Bond:
|Sample Bond||3.00%||6.00 Years|
Bond Math If Rates Increase by 1%
Yield -(Duration x Rate Increase) = Total Return
3.00% -(6.00 × 1%) = -3.00%
Source: OppenheimerFunds 2016. Table is for illustrative purposes only and does not predict or depict the performance of any particular investment.
Morningstar’s Intermediate-Term Bond category has a median duration of 5.4 years. A 5.4-year duration makes investors quite susceptible to interest rate risk. Just because bonds in the intermediate-term, investment-grade category do not have much credit risk, they are unquestionably not “risk free.”
The past 30 years of a largely declining interest rate environment has shielded fixed income investors from most of the harsh realities of interest rate risk. That, combined with a seemingly widespread perception that intermediate-term, investment-grade debt is “risk free” and “safe” has led to tremendous popularity of the category. Morningstar’s Intermediate-Term Bond category has about $1.1 trillion in assets under management as of Oct. 31, 2016, making it by far the largest fixed income category.
Senior loans may be attractive to investors seeking a potential hedge against higher interest rates due to their high yields and near zero duration. Senior loans have historically outperformed both investment-grade debt and U.S. Treasuries in most periods of rising rates, and senior loans are the only asset class of the three to generate positive average performance in the previous nine rising rate periods.
While no one knows with absolute certainty where rates will go from here, we have consistently asserted that one of the distinct and desirable attributes of senior loans is very low duration. (The other unique attributes of loans are the potential for high income, senior secured status in the capital structure, and diversification benefits). We encourage investors to reevaluate their fixed income portfolios with an eye towards understanding the balance between their exposures to interest rate risk and credit risk to help ensure they are comfortable with the overall risk they are taking. Given the losses many fixed income investors suffered during election week, it may also be wise to determine if now is the time to reduce the overall duration of their fixed income portfolios.
* “Senior Loans” represent an investment in a generic floorless senior loan, with a 90-day reset period.
The table is for illustrative purposes and does not predict or depict the performance of any particular investment.
Senior Loans are represented by the Credit Suisse Leveraged Loan Index, a composite index of senior loan returns representing an unleveraged investment in senior loans that is broadly based across the spectrum of senior loans and includes reinvestment of income (to represent real assets). Senior Loans are also represented by the JP Morgan Leveraged Loan Index, an index that tracks the performance of U.S. dollar denominated senior floating rate bank loans.
U.S. Treasuries are represented by the Barclays U.S. Treasury Index, an index of public obligations of the U.S. Treasury with a remaining maturity of one year or more.
Investment Grade is represented by the Barclays U.S. Aggregate Bond Index, an index of U.S.-dollar-denominated, investment-grade U.S. corporate, government, and mortgage-backed securities.
High Yield Bonds are represented by the J.P. Morgan High Yield Index, an index that tracks the investable universe of the below-investment-grade bonds in the United States.
U.S. Equities are represented by the S&P 500 Index.
The indices shown are unmanaged and cannot be purchased directly by investors. Index performance is shown for illustrative purposes only and does not predict or depict the performance of any Oppenheimer fund. Past performance does not guarantee future results.
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Mutual funds are subject to market risk and volatility. Shares may gain or lose value.
Short-term interest rates and longer term treasury rates may or may not move in tandem directionally or in magnitude.
Duration measures interest rate sensitivity. The longer the duration, the greater the expected volatility, as interest rates change.
Fixed income investing entails credit and interest rate risks. Interest rate risk is the risk that rising interest rates or an expectation of rising interest rates in the near future, will cause the values of a fund’s investments to decline. Risks associated with rising interest rates are heightened given that rates in the U.S. are at or near historic lows. When interest rates rise, bond prices generally fall, and a fund’s share prices can fall. Below-investment-grade (“high yield” or “junk”) bonds are more at risk of default and are subject to liquidity risk. Senior loans are typically lower-rated and may be illiquid investments (which may not have a ready market). Diversification does not guarantee profit or protect against loss.
These views represent the opinions of the Portfolio Managers at OppenheimerFunds and are not intended as investment advice or to predict or depict the performance of any investment. These views are as of the publication date, and are subject to change based on subsequent developments.