The last few years have been relatively favorable to fixed income portfolio managers. Between the Fed’s interest rate policy and a persistent bid from investors seeking shelter since the financial crisis, it has been hard to do any wrong. However, as central banks continue to push real rates into negative territory across the term structure, the chorus of observers preparing for an uptick in interest rates (whether it is due to credit spreads or GDP/inflation growth) has grown louder. This caution may be well deserved, especially considering that investors have been conditioned to expect positive and stable returns from the bond market over the last three decades.
We can take a closer look at the broad “rates higher” theme by using FactSet’s fixed income scenario tools. Before doing that, however, let’s quickly touch on the changes in composition of the bond market since the crisis. As illustrated below, the most striking transformation is in the mortgage and Treasury sectors. The chart below shows the Barclays Aggregate, but the same analysis could be performed on indices from Citi, Bank of America Merrill Lynch, or any other benchmark family.
The trends in this chart align pretty well with what you might expect given the economic environment; less mortgage issuance since the housing bubble and more Treasury issuance to sustain increased deficits. The duration profile is also pretty interesting:
Overall, duration has extended in the last few years but that change has been uneven across the curve, with the long end showing the most dramatic adjustment in interest rate sensitivity. Digging into this further, we can see how the 20 and 30 year key rates have changed per sector:
Treasuries and sovereigns have gotten a lot of press recently (with good reason sometimes), but it may be surprising to some that the corporate sector actually has the highest sensitivity to movements at the long end of the curve. Given how healthy balance sheets have gotten, companies are obviously doing a pretty good job of locking in long term funding, leaving core investment grade managers with few choices to pick up incremental yield.
So how bad would things get if rates did move up? By running a few simple scenarios, we can get a pretty good idea.
The first scenario is often associated with tighter Fed policy expectations and while the duration profile of corporates creates some differential in performance, the dispersion among sectors is fairly small. Although less probable, the steepener and parallel scenarios are where things get interesting. At this stage, we can use FactSet’s portfolio analysis tools to explore the sub-sectors and individual bonds that might hurt a portfolio most. In this example, these long-dated utility bonds could be your worst enemy if not hedged out:
We could take this further by changing spreads per sector, volatility assumptions, and prepay/losses on the securitized sector.