Many bond investors have taken on more interest rate risk to generate more yield
Fixed income yield has been difficult to come by recently. Putting it in perspective, yields on 10-year U.S. Treasuries were 15.8% in September 1981. By August 2020, they’d fallen to a low of 0.5%.
According to research by our Portfolio Construction Solutions team, to address this yield challenge, many financial professionals have recently increased their fixed income portfolio duration,1 a key measure of interest rate risk.
Average fixed income portfolio duration (years)
1 Duration refers to how long it takes for an investor to be repaid a given bond’s price by that bond’s total cash flows
Sources: T. Rowe Price Client Investment Platform (CIP) database and Morningstar Direct.
This may put clients in greater danger of portfolio losses as rates rise
With the economy recovering and supply chain issues, worker shortages, and pent-up consumer demand driving price spikes, inflation and rising rates have emerged as key risks for bond investors.
Historically, when inflation and interest rates go up, core bond values tend to go down, exposing investors to potential losses.
Floating rate and shorter-duration debt can help tackle this challenge
To position clients' portfolios for rising rates, consider floating rate and shorter-duration debt.
Interest payments on floating rate bank loans adjust, or float, based on their underlying benchmark rate. That means when interest rates go up, payments on floating rate funds may go up too (depending on the positions). This can help mitigate interest rate risk, though it's important to note that these loans are subject to more credit risk than higher-rated bonds.
Similarly, ultra-short duration bonds essentially reset in as little as 90 days, meaning investors have a lower risk of unfavorable price changes as interest rates rise. Dive deeper with our portfolio construction insight, Fixed Income: What To Do Now?
Floating rate and ultra short-term debt outperformed traditional fixed income sectors during the latest interest rate spike*
Comparing SEC yield, total return, and duration for Morningstar fixed income categories
*Interest rate spike refers to the period between August 5, 2020, through March 31, 2021, when yields on 10-year U.S. Treasuries rose from 0.5% to 1.7%. Total return is measured from August 5, 2020, through March 31, 2020. Effective duration and SEC yield are measured as of March 31, 2021.
Past performance is not a reliable indicator of future performance. Category average performance is for illustrative purposes only and is not representative of any specific investment product.
Sources: Morningstar Direct. Analysis by T. Rowe Price.
With a highly collaborative global research platform underpinning a full range of fixed income strategies, we can help you and your clients feel more confident about achieving long-term goals.
More flexibility in fixed income may help reduce volatility
No one knows how long uncertainty in fixed income markets will persist. The global pandemic, tapering, inflation, and near-zero interest rates make for a murky picture. Yet whatever the conditions, long-term investors seek consistent income and defense against potential threats to their portfolio—such as stock market volatility and credit defaults or downgrades within particular sectors or geographies.
To that end, active multi-sector bond strategies have two advantages over more narrowly-focused traditional bond strategies, especially those that follow more passive signals (though including both in a portfolio may be optimal).
This can help investors generate returns in all market environments.
Unlock a broader opportunity set for clients with global multi-sector bonds
Given the low yields and looming risks that characterize today’s fixed income landscape, bond investors need access to as many good opportunities as possible. Global multi-sector bond strategies are one way to widen that scope relative to more typical sources of fixed income, such as the Bloomberg U.S. Aggregate Bond Index (chart on the left). This proxy for core bonds limits investors to just 38% of the total opportunities available within the fixed income universe (shown on the right).
The global bond market provides greater opportunity to adapt to different market environments
Sources: Bloomberg Index Services Limited, SIFMA. As of July 28, 2021.
In choosing a multi-sector manager, selecting a partner with the commitment and resources needed to identify solid opportunities across a broader universe of investment options is crucial. Dive deeper with multi-sector insights straight from our fixed income experts.
Higher taxes are likely ahead: Help your clients keep more of their money
As the Biden administration considers policy changes that include a potential increase in personal income tax rates, generating more tax-free income and increasing the tax efficiency of clients’ taxable portfolios may assume greater importance.
Indeed, higher tax rates would actually widen the existing discrepancy between before-tax and after-tax returns. This increases the appeal of investments offering tax-advantaged income, particularly for high-earning and high-net-worth clients who are subject to higher tax rates.
Access a powerful tool that can increase tax efficiency
Municipal bonds have long been an effective tool for providing tax-advantaged returns, as income received from municipal bonds is generally exempt from taxes at the federal level. The exemption may also apply at the state and local levels for investors who live in the issuing state.
With this preferential tax treatment, municipal bonds can be a powerful tool in building more tax-efficient portfolios. They can also offer meaningful diversification benefits with low correlations to equities.
Municipal bonds can help you achieve better returns after taxes
Comparing pretax and after-tax returns for commonly used bond types (listed below) shows taxable bonds outpacing municipal bonds on a pretax basis. However, municipal bonds came out on top for after-tax returns.
Municipal bonds offered strong post-tax return potential
Bonds: 15-year pretax and after-tax returns
Past performance cannot guarantee future results.
As of June 30, 2021.
Source: Morningstar Direct.
Calculation Benchmark: Morningstar Category Averages.
Category average performance is for illustrative purposes only and is not representative of any specific investment product. To learn more about the after-tax methodology used, see Additional Disclosures.
When it comes to munis, choose carefully
While municipal bonds offer compelling benefits, the muni market is fragmented across many small issuers. Therefore, it’s essential to find strategies for your clients that apply rigorous fundamental credit research—identifying top opportunities and prudently managing risk. Take a closer look at ways to incorporate tax efficiency into your investment models.
1166 of our 377 mutual funds had a 10-year track record as of 6/30/21. (Includes all share classes and excludes funds used in insurance products.) 126 of these 166 funds (76%) beat their Lipper average for the 10-year period. 229 of 365 (63%), 257 of 356 (72%), and 212 of 304 (70%) of T. Rowe Price funds outperformed their Lipper average for the 1-, 3-, and 5-year periods ended 6/30/21, respectively. Calculations based on cumulative total return. Not all funds outperformed for all periods. (Source for data: Lipper Inc.)
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After-tax returns provide an estimate of a fund’s annualized tax- and load-adjusted total return for the time period specified. Morningstar’s data is consistent with the SEC’s 2001 guidance about after-tax returns, and it is updated as needed to reflect changes in the federal tax code. Taxes are a significant consideration for many investors who own mutual funds in taxable accounts. When a fund receives a stock dividend or interest from a bond, it will divide that dividend among its shareholders, and when a fund sells a security at a gain, it will divide that capital gain among its shareholders. Investors pay taxes on these dividends and capital gains, and they may also pay taxes on capital gains when they sell the fund. Investors can compare the total return, load-adjusted return, and after-tax returns for a fund to understand how loads and taxes affect the performance of the fund. Investors can also use after-tax returns to compare one fund to another. Morningstar calculates after-tax returns in-house on a monthly basis, using price and distribution data for each fund for different time periods. Morningstar calculates after-tax returns for open-end mutual funds, exchange-traded funds, and variable annuity underlying funds. This description applies to those funds that are domiciled in the United States.
The after-tax returns calculation is based on a few underlying assumptions that may cause the results to be slightly different than what each individual investor experiences. Per the SEC’s guidance, Morningstar uses the highest federal tax rate prevailing for each type of distribution. These results simulate the tax effects for an individual in the highest tax bracket. After-tax distributions are reinvested. State and local taxes as well as individual-specific issues are ignored. Per the SEC’s guidance about this topic, all after-tax returns are also adjusted for loads and recurring fees. Therefore, these are technically “tax- and load-adjusted returns” and not simply “tax-adjusted returns.” A fund’s after-tax return may be lower than its total return because of tax effects, sales charges, or both. Morningstar uses the maximum front-end load and the appropriate deferred loads or redemption fees for the time period measured. Sales loads are not applied to reinvested distributions. Morningstar applies the appropriate historical tax rate based on the date of the distribution. The current tax rates are as follows: 35% interest income and non-qualified dividends, 15% qualified dividends, 35% short-term capital gains, 15% long-term capital gains. For municipal bond funds, Morningstar will only adjust for capital gains taxes, as the income from these funds is generally exempt from federal tax.
This material is provided for general and educational purposes only and not intended to provide legal, tax, or investment advice. This material does not provide recommendations concerning investments, investment strategies, or account types; it is not individualized to the needs of any specific investor and not intended to suggest any particular investment action is appropriate for you, nor is it intended to serve as the primary basis for investment decision-making.
Past performance cannot guarantee future results. All investments are subject to market risk, including the possible loss of principal. Fixed-income securities are subject to credit risk, liquidity risk, call risk, and interest-rate risk. As interest rates rise, bond prices generally fall. International investments can be riskier than U.S. investments due to the adverse effects of currency exchange rates, differences in market structure and liquidity, as well as specific country, regional, and economic developments. Floating rate bank loans are usually considered speculative and involve a greater risk of default and price decline than higher-rated bonds. Some municipal bond income may be subject to state and local taxes and the federal alternative minimum tax. Diversification cannot assure a profit or protect against loss in a declining market.
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