By SJS Director of Institutional Investment Management Kirk Ludwig
Whether you’re an SJS client living in Ohio or Arizona – or somewhere in between – chances are good that you have experienced an environmental drought at some point during your lifetime.
In the bond market, we have been experiencing our own version of a “drought” over the past decade – a shortage of income (or, yield) from our bonds, with respect to the fixed income allocations in our MarketPlus® portfolios. A drought begins and intensifies when there is a continued shortage of rainfall. Over time, the ground dries up. The “green” goes away as plants, shrubs, and trees die or fall dormant. The ground remains fertile but, in the absence of precipitation to generate new growth, crops fail to produce their yield.
Typically, we think of bonds, or fixed income, as the “safer” part of our portfolios, since they generate income while providing portfolio stability. However, since the Great Recession in 2007, short-term bond rates have hovered near zero percent, evaporating any income from this part of the portfolio.[1] Now that the U.S. economy is feeling more stable, the Federal Reserve has increased their target rate to 2.25%, which in turn has showered the bond market with a much needed income boost.[2]
Similar to how a gentle rainfall would not immediately end a weather drought, a gradual increase in interest rates doesn’t automatically lead to higher income. When interest rates go up, the principal value of a bond will actually adjust lower to make up for the higher market rate. This adjustment period often dampens fixed income returns in the short-term, but leads to a higher income stream in the future. As a result, the returns in fixed income investments year-to-date in your portfolio have been fairly flat.
We are eager to start capturing greater yields, but we have to be patient. In the current interest rate environment, the bond portion of our MarketPlus portfolios will gradually start capturing the increase in rates as shorter-term bonds mature and proceeds are reinvested at today’s higher yields. The Federal Reserve will likely continue to raise short-term rates in the near future, which means bond returns may continue to be flat for a while. However, we believe that we will soon start to see evidence of higher yields as they sprout within the portfolios.
A recovery following a drought is gradual. It doesn’t happen like a flood – instantly inundating. The recovery occurs by having a steady, soaking rain for a few days or more. Before you know it, your resources are recovering and the drought has ended.
Our hope is that our client portfolios start to benefit from these drought-ending rate increases, and that their future “harvest” will be more bountiful.
Sources:
[1] Daily Treasury Yield Curve Rates, U.S. Department of the Treasury.
[2] U.S. Rates and Bonds, Bloomberg.com.
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