April 23, 2013
|Mike Gitlin, T. Rowe Price's director of Fixed Income|
Falling interest rates have boosted bond and bond fund returns for the past few years due in part to unprecedented central bank intervention. But the economy is recovering, and Federal Reserve officials are considering when to curtail or stop asset purchases. We recognize that interest rates will eventually rise from historic lows. However, we do not believe that a "bond bubble" is about to burst or that investors should sell all of their fixed income investments before rates rise. We believe bonds should remain an important component of an investor's portfolio. Bonds provide a regular stream of income and diversification. They are generally less volatile than stocks, and they can help investors achieve their long-term financial goals. The following reflects the views of Mike Gitlin, T. Rowe Price's director of Fixed Income.
Bond investors have enjoyed favorable—in some cases, excellent—total returns over the last four years. Bond prices have appreciated as Treasury interest rates have fallen to historic lows, and yields on lower-quality securities, in particular, have declined significantly since the end of 2008. Several factors have boosted bond prices, but investors have benefited in large part as the Federal Reserve has implemented unprecedented stimulus measures—including purchases of Treasuries and agency mortgage-backed securities—to suppress interest rates, boost liquidity, and encourage economic expansion.
Charts in this article are for illustrative purposes only and are not intended to represent any specific security. Past performance cannot guarantee future results.
While fixed income securities have performed well in recent years, we are mindful that this performance pattern is unlikely to continue indefinitely. Bond valuations in many sectors are stretched, and with interest rates at such low levels, the potential for meaningful bond price appreciation is limited. We believe that investors should be aware of the prospect for rising rates. While we feel it is important to highlight the reality of interest rate risk, we do not subscribe to the cataclysmic view that a "bond bubble" is about to burst or that investors should sell all of their fixed income investments before rates rise. Interest rates are low for several reasons, including modest economic growth, high levels of unemployment, contained inflation expectations, and the actions of the Federal Reserve. It's possible that rates could stay low for some time. But with the economy recovering and Fed officials considering when the central bank should curtail and stop its asset purchases, it is only a matter of time before interest rates rise from ultra-low levels, which will weigh on bond prices. Our interest rate strategy and economics teams regularly make forward-looking projections of rates and yield curves, and these assessments are incorporated in our investment strategies. Even when rates return to more normal levels, bonds will remain an important asset class, and we expect to continue finding good investment opportunities for income-seeking investors.
Fundamental research is a hallmark of T. Rowe Price's risk-aware investment approach. We analyze a bond issuer's financial situation and prospects thoroughly and independently before making any decision to buy or sell a security. We believe that this is how we can best add value for our bond fund investors over time.
We actively manage our bond portfolios and, as we analyze economic and market developments daily, strive to minimize risk while staying focused on our long-term objectives. We cannot control the direction of interest rates, so we do not typically make investments where a favorable outcome depends primarily on which way interest rates move. As a result, we tend to keep our bond portfolios' duration—a measure of interest rate sensitivity—within a range relative to their benchmarks. If we determine that rates are about to rise significantly or for an extended period, we may decide to reduce our bond portfolios' duration to help preserve value for our investors.
You can look at your fund's duration—in a recent shareholder report or on our website—to get an idea about how its net asset value would respond to interest rate fluctuations. For example, an intermediate-term bond fund with a duration of five years would fall about 5% in price in response to an instantaneous one-percentage-point rise in interest rates. The opposite is also true: A fund with a five-year duration would rise about 5% in price in response to an immediate one-percentage-point decline in interest rates. Importantly, instantaneous moves of this magnitude are unlikely and typically happen over a period of time, during which the portfolio's yield would augment gains or help offset a price decline. Keep in mind that bonds vary in terms of issuer, maturity, and credit quality, so not all bonds respond to interest rate fluctuations in the same way.
Some funds are subject to a greater degree of interest rate risk. For example, the T. Rowe Price U.S. Treasury Long-Term Fund must invest at least 85% of its assets in U.S. Treasury securities. While Treasury notes and bonds have proven an effective hedge against market turmoil, their long-term nature and historically low yields have subjected holders to greater interest rate risk than in recent years. The duration of the U.S. Treasury Long-Term Fund stood at 16.4 years at the end of March 2013. While we have some flexibility to manage interest rate risk by keeping the portfolio's average duration shorter than that of its benchmark, our mandated focus on longer-maturity securities puts the fund at risk of generating negative total returns should interest rates markedly rise.
Although bond prices fall when interest rates rise, we remain convinced that bonds should continue to have a place in most investors' portfolios.
- Bonds generate income on a regular basis that can help offset losses or augment positive returns. As rates rise, newly issued bonds will produce higher levels of income.
- Bonds are issued by a wide variety of entities—including national and municipal governments, government agencies, and corporations—that can help diversify the risks of an equity portfolio to varying degrees.
- Fixed income securities tend to be less volatile than equities and, therefore, should become a larger allocation in the portfolio of an investor who is getting closer to reaching a long-term financial goal, such as retirement.
We think investors should be cautious about making sudden or dramatic shifts in their portfolios into or out of bonds, stocks, or any asset class. Such moves may significantly affect your portfolio's overall risk profile and may make it harder to achieve your financial goals. Our own asset allocation portfolios are designed to help clients reach their financial goals by incrementally changing exposure to bonds and stocks over time.
Even as an increase in U.S. interest rates appears to be getting closer, we are finding good investment opportunities in pockets of the fixed income universe.
Bank loans constitute the majority of the holdings in the T. Rowe Price Floating Rate Fund. These collateralized securities are sub-investment grade and carry greater credit risk than higher-rated investment-grade securities. That said, bank loans occupy the highest position in a company's capital structure and offer attractive yields, and the interest rate duration of the fund is very low due to the floating rate nature of bank loan coupon payments. Should the economy continue to improve, default rates are likely to remain low, and the fund has the opportunity to generate attractive returns with very little interest rate risk. Please note these loans are considered speculative and involve a greater risk of default than higher-rated bonds.
We are also finding value in BBB rated municipal bonds held by the T. Rowe Price Tax-Free High Yield Fund.* Our credit research team helps Portfolio Manager Jim Murphy to navigate the broad universe of municipal securities.
We also think investors should consider select non-U.S. bonds, which have appealing characteristics. The T. Rowe Price Emerging Markets Corporate Bond Fund invests primarily in dollar-denominated emerging corporate debt across the credit quality spectrum. The T. Rowe Price Emerging Markets Local Currency Bond Fund invests primarily in emerging market sovereign debt issued in local currencies. Each fund has a duration of approximately 5.0—5.5 years. Emerging market countries, on average, have lower debt-to-gross domestic product ratios than developed market countries and higher economic growth rates. It is important to note that emerging market securities can be more volatile than developed market securities. Market liquidity in the underlying markets can be challenging, and the risk of inflation historically has been greater than that in developed market countries. Currency risk poses an additional risk not typical of domestic funds. However, we believe the bonds have the potential to generate good returns over time given better growth prospects in emerging economies.
We believe that investors need to be mindful of interest rate risk as rates are at historically low levels and central bank accommodation is at an all-time high (the Fed's balance sheet exceeds $3 trillion following multiple rounds of quantitative easing measures). We want to share opportunities with our investors that we believe remain attractive, but we want you to be aware of these risks. As always, we advocate a balanced investment approach that is aligned with your individual long-term goals.
Bonds are subject to interest rate risk (the decline in bond prices that usually accompanies a rise in interest rates) and credit risk (the chance that any fund holding could have its credit rating downgraded or that a bond issuer will default by failing to make timely payments of interest or principal), potentially reducing the fund's income level and share price. High yield bonds carry a significant level of credit risk.
*Some income from the Tax-Free High Yield Fund may be subject to state and local taxes and the federal alternative minimum tax.
Diversification cannot assure a profit or protect against loss in a declining market.