Bonds won’t suffer when Fed ups rates, experts say

If you’re concerned that the Federal Reserve will derail the bond market when it finally starts raising interest rates, the last two tightening cycles suggest those worries may be overblown.

Instead of tumbling, U.S. debt securities from Treasurys to junk bonds gained. They returned an average 5.7 percent between June 2004 and June 2006, when the Fed lifted rates to 5.25 percent from 1 percent. In the seven months ended January 2000, bonds retained their value even as benchmark borrowing costs increased 1.75 percentage points.

With the U.S. economy expanding at a slower pace and less wage growth to pressure inflation, there are fewer reasons for the Fed to raise rates as quickly this time as the central bank moves to end six years of unprecedented stimulus. Long-term bond yields that offer a greater cushion against higher rates than in previous cycles and demand for fixed income from a burgeoning number of retirees also suggest the inevitable selloff forecasters have predicted is less likely to materialize.

“It would be a mistake to bet against the bond market,” Priscilla Hancock, global fixed-income strategist at JPMorgan Asset Management, which handles $1.5 trillion, said last week. “The road to higher rates will be a long, slow march at a time when income is the most important thing. That means fixed income will still be an important place to be.”

In the U.S., debt securities of all types have rallied this year, confounding forecasters’ projections for losses, index data compiled by Bank of America Merrill Lynch show. Their 4.14 percent return is the biggest since 2010.

Yields on 10-year Treasurys, the benchmark for securities as varied as mortgages, corporate bonds and emergingmarket sovereign debt, have fallen more than a half-percentage point to about 2.5 percent.

Intensifying debate

The debate over the Fed’s interest-rate policy and its effect on bonds has been intensifying as the central bank moves closer to ending its monthly debt purchases, which has helped inundate the U.S. economy with more than $3 trillion of cheap cash since 2008 and propped up asset prices.

The stakes have never been higher. In just six years, the global market for bonds has ballooned more than 40 percent to a record $100 trillion, according to estimates from the Bank for International Settlements.

There’s now a 60 percent chance the Fed, which has held borrowing costs close to zero since 2008 to restore an economy crippled by its worst crisis since the Great Depression, will start raising rates by July 2015, futures contracts show.

Last month, the Fed itself predicted the target rate will rise to 1.13 percent at the end of next year and 2.5 percent a year later, according to the median projection of 16 policymakers. Based on their long-term growth outlook, they anticipate stopping once rates reach about 3.75 percent.

That indicates borrowing costs will increase less than in the previous cycle, when they climbed 4.25 percentage points, and rise at a slower pace than in 1999-2000, when rates ended at 6.75 percent.

One reason is because the five-year expansion is still showing signs of weakness. Last quarter, the U.S. economy contracted 2.9 percent, the deepest drop-off since the 2009 recession. Economists say growth will accelerate 3 percent next year when the Fed starts raising rates. That would still be slower than the 3.8 percent expansion in 2004 and fall short of the more than 4 percent pace in 1999 and 2000.

Along with fewer rate increases, investors also have an advantage in higher relative yields as a buffer when the Fed does decide to lift borrowing costs.

Treasurys due in 30 years offer 1.61 percentage points more in yield than five-year notes.

That’s more than the average 1.01 percentagepoint gap in the year before every tightening cycle since 1980. The cushion is similar to the one investors had before the Fed started raising rates in 2004, which helped support bond returns.

“An increase in rates doesn’t have to mean rising yields,” Guy Lebas, the chief fixed-income strategist at Janney Montgomery Scott LLC, which manages $61 billion, said Sunday. “The actual event of a rate increase is far less important than it has been.”

History lesson

For the bond bears, historically low yields mean the margin of error is much smaller and makes 1994 a more accurate picture of the risks investors face when the Fed boosts rates.

That year, the Bank of America Merrill Lynch U.S. Broad Market Index of bonds fell 2.75 percent in its worst-ever loss, when then-Fed Chairman Alan Greenspan surprised investors by doubling its benchmark rate to 6 percent.

Based on the index, U.S. bonds now yield 2.21 percent, less than half the average of 4.84 percent. A gauge known as duration, which calculates how much prices change when yields rise or fall, has climbed to 5.64, within 0.1 of a record.

“Yields don’t have to rise that much to redistribute significant losses to bondholders,” Christopher Sullivan, who oversees $2.3 billion as chief investment officer at United Nations Federal Credit Union, said last week. “The risks inherent in bonds are certainly higher.”