October 22, 2013

After several years of outstanding returns, bond markets have struggled recently amid rising interest rates and potentially changing Federal Reserve policies. Bonds rallied late in the third quarter, though, as the Fed decided to postpone a planned tapering of its stimulative quantitative easing (QE) program. Andy McCormick manages T. Rowe Price's U.S. taxable bond team and has managed the GNMA Fund for the past five years. In a recent interview, he discussed the current fixed income environment and outlook.

Impact of Fed Backpedal

After its September meeting, Fed Chairman Ben Bernanke announced that the Fed would delay tapering its QE asset purchases and continue to monitor the economic recovery and unemployment. Bond markets rallied as investors took the news as a sign that interest rates may stay lower longer than previously expected. But the reprieve may not last. McCormick believes that volatility will continue as long as the central bank continues to play such a major role in markets, as investors will hang on news from the Fed in search of a road map.

Rising Rates Affect Bond Performance

Fixed income sectors that performed well this past quarter were those that are less sensitive to interest rate fluctuations, such as high yield bonds, floating rate bank loans, and non-agency mortgages. Likewise, emerging markets issues reacted more dramatically to the potential of Fed tapering than developed markets. However, performance was uneven even in these sectors, and McCormick says individual security selection is crucial to finding promising opportunities in a rising rate environment.

Outlook Mixed for Bond Markets

McCormick says the bond bull market of the recent past is coming to a close. The economic recovery is progressing at a slow pace, but the job market is improving, as is housing. Interest rates will drift up, but more gradually than they did during the recent spike. In the past, the investor reflex when volatility rose was to flock to Treasuries, but in this distorted and low-yielding market, investors will need to balance liquidity needs with the desire to earn returns from diversified sources. McCormick suggests keeping a long-term perspective, rather than reacting to daily news.

Yield and share price will vary with interest rate changes. Investors should note that if interest rates rise significantly from current levels, bond fund total returns will decline and may even turn negative in the short term. The fund is also subject to prepayment risk.

The views are as of October 3, 2013, and may have changed since that time. This information is provided for informational purposes only and is not intended to reflect a current or past recommendation or investment advice of any kind. Opinions and commentary do not take into account the investment objectives or financial situation of any particular investor or class of investor. Investors will need to consider their own circumstances before making an investment decision.