A flatter yield curve — time to derisk?
October 19, 2018
The US Treasury yield curve has flattened significantly over the past six months with tighter monetary policy and lower expectations of inflation. The difference between 2-year and 10-year US Treasury yields is now (as of Sept. 30, 2018) less than 50 basis points, which is the lowest it has been since August 2007. (A basis point equals one hundredth of a percentage point.)
As noted in the chart below, in periods when the difference between 2-year and 10-year US Treasury yields has been less than 50 basis points, higher-quality fixed income investments, specifically intermediate-term bond funds, tended to outperform equities and other higher-risk fixed income sectors such as high yield and bank loans.
Implications for investors
A flattening yield curve is generally indicative of behavior in the later stages of the credit cycle, including increased volatility and lower returns for riskier assets such as equities and high yield bonds. Now may be an appropriate time to consider reducing exposure to equities and high yield in favor of an intermediate-term bond solution, particularly one that has the flexibility to use a broad toolkit to manage through changing market conditions.
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The views expressed represent the Manager's assessment of the market environment as of October 2018, and should not be considered a recommendation to buy, hold, or sell any security, and should not be relied on as research or investment advice. Views are subject to change without notice and may not reflect the Manager's views.
The Morningstar Bank Loan Category compares funds that primarily invest in floating-rate bank loans instead of bonds. In exchange for their credit risk, these loans offer high interest payments that typically float above a common short-term benchmark such as the London interbank offered rate, or LIBOR.
The Morningstar High-Yield Bond Category compares funds that concentrate on lower-quality bonds, which offer higher yields than other types of portfolios but are also more vulnerable to economic and credit risk. These funds primarily invest in US high-income debt securities where at least 65% or more of bond assets are not rated or are rated by a major agency such as Standard & Poor's or Moody's at the level of BB (considered speculative for taxable bonds) and below.
The Morningstar Intermediate-Term Bond Category compares funds that invest primarily in corporate and other investment grade US fixed income issues and typically have durations of 3.5 to 6.0 years. These funds are less sensitive to interest rates, and therefore less volatile, than funds that have longer durations.
The Morningstar Multisector Bond Category compares funds that seek income by diversifying their assets among several fixed income sectors, usually US government obligations, US corporate bonds, foreign bonds, and high yield US debt securities. These funds typically hold 35% to 65% of bond assets in securities that are not rated or are rated by a major agency such as Standard & Poor's or Moody's at the level of BB (considered speculative for taxable bonds) and below.
The Morningstar Nontraditional Bond Category contains funds that pursue strategies divergent from conventional practice in the broader bond-fund universe. These funds typically include: a mix of absolute return mandates; goals of producing returns not correlated with the overall bond market; performance benchmarks based on ultrashort-term interest rates such as federal funds, T-bills, or the London interbank offered rate (LIBOR); the ability to use a broad range of derivatives to take long and short market and security-level positions; and few or very limited portfolio constraints on exposure to credit, sectors, currency, or interest rate sensitivity. Funds within this category typically have the flexibility to manage duration exposure over a wide range of years and to take it to zero or a negative value.
The S&P 500® Index measures the performance of 500 mostly large-cap stocks weighted by market value, and is often used to represent performance of the US stock market.
Index performance returns do not reflect any management fees, transaction costs, or expenses. Indices are unmanaged and one cannot invest directly in an index.
IMPORTANT RISK CONSIDERATIONS
Investing involves risk, including the possible loss of principal.
Past performance does not guarantee future results.
Fixed income securities and bond funds can lose value, and investors can lose principal, as interest rates rise. They also may be affected by economic conditions that hinder an issuer’s ability to make interest and principal payments on its debt.
The fund may also be subject to prepayment risk, the risk that the principal of a bond that is held by a portfolio will be prepaid prior to maturity, at the time when interest rates are lower than what the bond was paying. A portfolio may then have to reinvest that money at a lower interest rate.
High yielding, non-investment-grade bonds (junk bonds) involve higher risk than investment grade bonds.
The high yield secondary market is particularly susceptible to liquidity problems when institutional investors, such as mutual funds and certain other financial institutions, temporarily stop buying bonds for regulatory, financial, or other reasons. In addition, a less liquid secondary market makes it more difficult for the Fund to obtain precise valuations of the high yield securities in its portfolio.
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