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Bonds Not Doomed by Rising Rates

by Community Manager

‎02-21-2014 12:40 PM

Market CommentaryBy Arne Espe,
Vice President, Mutual Fund Portfolios


Even as the Federal Reserve approved the second round of its monetary tapering last month, it reassured jittery investors that short-term interest rates would remain at near-zero levels well into the future.


But the minutes from that January meeting, released to the public this week, tell a different story. The inevitable rate hike debate within the Fed appears to be underway, with some members pushing for an upward move “relatively soon” to head off potential inflation.


Surely, you may be thinking, the combination of an improving U.S. economy, reduced monetary stimulus and the possibility that the lid on rates could be lifted sooner than expected makes the case for getting out of bonds.


We currently have an underweight to fixed income in our asset allocation models, but we don’t agree with abandoning bonds altogether for a few reasons.


First, bonds have a place in a well-diversified, long-term investment portfolio. Their returns tend not to be closely correlated to stocks (some corporate bonds being an exception) and other asset classes, and the risk associated with those returns is lower. Bonds provide a measure of portfolio protection when stocks are volatile, as we’ve seen in the opening weeks of 2014. In our view, building a diversified portfolio is like building a baseball team — you can’t expect to win the World Series with a roster of just pitchers and catchers. You also need hitters, fielders and base stealers.


Second, while the forecast calls for faster economic growth this year, there’s no guarantee that the economy will actually deliver — and lately the signals have been mixed. After 2013’s strong fourth quarter, some key indicators have fallen off. This week, the New York Fed’s Empire State index of U.S. business activity for February came in well below expectations. Bonds stand to perform well in a slower-growth environment.


And third, as we like to say, we look at it as a “market of bonds” rather than a “bond market.” By this, we mean there’s a breadth of debt securities that don’t respond to rate changes or other market conditions in a uniform way. As an asset class, bonds offer a wide range of risk and return characteristics that may be attractive to investors, based on their investment objectives.


As bottom-up bond pickers, we have been able to purchase bonds with a significantly higher yield than Treasuries without taking on much additional risk. We prefer credit risk to interest rate risk in the current environment. This positioning leads us to prefer asset-backed securities and corporate bonds (including high-yield issues) over Treasury bonds.


Default rates are near an all-time low, so credit risk is muted, and these bonds tend to outperform when interest rates are gradually rising. And when we can find them, we are selective buyers of floating-rate bonds and bonds with “negative duration” because their price tends to rise as their yield rises, which defies the usual inverse relationship between bond price and yield. And if the yield on Treasuries backs up toward 4%, as some expect by year-end, we’ll own more of them.


While it has started winding down its economic stimulus, the Fed is still an early arrival at the monetary tightening party. The Bank of England is holding firm on its expansionary program, while the European Central Bank and the Bank of Japan are considering further easing measures. This “loose and looser” policy approach elsewhere in the developed world could lead to appreciation of the dollar and thus of Treasury prices, and could benefit other bonds by putting a damper on U.S. interest rate increases.

For more on what we see ahead for investors this year, we invite you to read our 2014 investment outlook.       


USAA Investments Managed Portfolio Outlook


Our view of caution toward U.S. equities remains unchanged. We remain slightly overweight in cash in our diversified managed portfolios. For investors interested in income-oriented bond investments, the USAA Intermediate-Term Bond Fund, the USAA High Income Fund and the USAA Income Fund are examples. For investors interested in tax-free income, the USAA Tax Exempt Long-Term Fund, the USAA Tax Exempt Intermediate-Term Fund and the USAA Tax Exempt Short-Term Fund are examples.


We also are overweight to assets that are positively correlated to inflation expectations. The USAA Real Return Fund also provides potential protection against the risks of long-term inflation.


Emerging markets represent another opportunity. Though they were hit especially hard recently, we believe that emerging markets remain attractive. They offer both an interesting long-term prospect for growth and compelling valuations. The USAA Emerging Markets Fund offers exposure to stocks in less-developed countries.


As always, we encourage investors to speak with one of our financial advisors, who can help determine which investment vehicles are best suited for you based upon your individual goals, objectives, risk tolerance and time horizon.




This material is for informational purposes and is not investment advice, an indicator of future performance, a solicitation, an offer to buy or sell, or a recommendation for any security. It should not be used as a primary basis for making investment decisions. Consider your own financial circumstances and goals carefully before investing.


Consider the investment objectives, risks, charges and expenses of the USAA mutual funds carefully before investing. Contact us at 1-800-531-8910 for a prospectus containing this and other information about the funds from USAA Investment Management Company, Distributor. Read it carefully before investing.


Investing in securities products involves risk, including possible loss of principal.


Past performance is no guarantee of future results.


As interest rates rise, existing bond prices fall.


Non-investment grade securities are considered speculative and are subject to significant credit risk. They are sometimes referred to as junk bonds since they represent a greater risk of default than more creditworthy investment-grade securities.


Some income may be subject to state or local taxes or the federal alternative minimum tax.


Foreign investing is subject to additional risks, such as currency fluctuations, market illiquidity, and political instability. Emerging market countries are most volatile. Emerging market countries are less diverse and mature than other countries and tend to be politically less stable.


Precious metals and minerals is a volatile asset class and is subject to additional risks, such as currency fluctuation, market liquidity, political instability and increased price volatility. It may be more volatile than other asset classes that diversify across many industries and companies.


The S&P 500 Index is a well-known stock market index that includes common stocks of 500 companies from several industrial sectors representing a significant portion of the market value of all stocks publicly traded in the United States. Most of these stocks are listed on the New York Stock Exchange.


USAA or its affiliates do not provide tax advice. Taxpayers should seek advice based upon their own particular circumstances from an independent tax advisor.


High double digit returns are attributable, in part, to unusually favorable market conditions and may not be repeated or consistently achieved in the future.


Financial planning services and financial advice provided by USAA Financial Planning Services Insurance Agency, Inc. (known as USAA Financial Insurance Agency in California, License #0E36312), a registered investment adviser and insurance agency and its wholly owned subsidiary, USAA Financial Advisors, Inc., a registered broker dealer.


Investments provided by USAA Investment Management Company and USAA Financial Advisors Inc., both registered broker dealers.


The Real Return Fund may be subject to stock market risk and is non-diversified which means that it may invest a greater percentage of its assets in a single issuer. Individual stocks will fluctuate in response to the activities of individual companies, general market, and economic conditions domestically and abroad. When redeemed or sold, may be worth more or less than the original cost.


Managed Accounts is a service of USAA Investment Management Company (USAA), a registered investment adviser and broker dealer.


Diversification does not guarantee a profit or prevent a loss.

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