July 12, 2013

Since the global financial crisis and recession of 2007-2009, the Federal Reserve has taken extraordinary measures to keep interest rates low: maintaining the federal funds rate at nearly 0% since December 2008, and aggressively purchasing bonds, which has driven up their prices and kept interest rates low. But now that the Fed has signaled it will probably begin unwinding its substantial positions in Treasuries and other fixed-income holdings later this year, higher interest rates may be on the way. Investors need to understand what is happening in the fixed-income market and the potential effects on their portfolios. In a higher-interest-rate environment, we believe there are four factors to consider when designing a fixed-income strategy.

1. Diversification matters.

Bonds sensitivity to interest-rate movements can differ substantially based on duration, credit quality, and type of security. For example, in 2009 interest rates increased sharply, with the yield on the bellwether 10-year Treasury note climbing from 2.46% to 3.85%. Longer-term, higher-rated bond sectors tended to underperform during this period, while shorter-term, lower-rated, and securitized assets outperformed. In some cases, the disparity in performance among categories was dramatic, underscoring the value of diversification.

Looking forward, investors should consider that the highest-quality securities will be especially hard hit when the Fed begins to taper its bond purchasing program, but there may be an impact on other fixed-income sectors as well. To help mitigate risk, investors may want to consider fixed-income portfolios that are designed to maintain diversified exposure across a broad range of sectors and security types.

2. Active management offers flexibility.

Since the Great Recession, the Treasury sector weighting in the Barclays U.S. Aggregate Bond Index has grown from 25.1% to 36.4% largely due to increased issuance by the U.S. Treasury. Corporate bonds have also grown as a share of the index (albeit to a lesser degree), with companies taking advantage of low rates to refinance debt and extend maturities. Meanwhile, since the housing bust, issuance of many securitized assets including mortgage-backed securities (MBS) and commercial mortgage-backed securities (CMBS) decreased significantly.

For investors who use bond indexing strategies, this shift in issuance has resulted in portfolios with more Treasury securities, longer duration, and heightened sensitivity to interest rates.

Active managers, on the other hand, can more easily compensate for this shift in the overall mix. They have greater flexibility to buy fewer Treasuries and seek out higher-yielding, non-Treasury debt instruments that offer compelling relative value, generate sustainable income, and will be resilient under a range of economic circumstances.

3.Think long-term

Our analysis shows that bond markets tend to be resilient, bouncing back from initial losses when rates rise. For example, based on previous periods when interest rates were less than 3.5% but increasing, intermediate-term government bonds realized losses of 1%-3% over one-year time frames. As illustrated in Exhibit B, however, these short-term losses reversed over the medium-term. In fact, average annualized returns for medium-term U.S. government bonds have been positive for all rolling three-year periods since 1926.

Of course, there is no guarantee that fixed-income markets will repeat this pattern of short-term reversals in the next interest-rate cycle. The past may provide useful context but is not a predictor of future outcomes, as economic and market conditions are never identical. This caveat is especially relevant in the current environment, given the lack of historical precedent for the degree of market support that has been provided through the Feds QE programs, and uncertainty as to how credit markets may respond when this support is withdrawn.

But investors would be wise to think long-term, stick to an investing strategy, and not try to time the rise and fall of interest rates. The risk of being underexposed to fixed income may outweigh the risk of being exposed to rising interest rates. Todays investors can also take some comfort in the knowledge that the Fed would probably step in should interest rates rise too fast or far; a rate increase of 1%, for example, would have adverse implications for the fledgling housing recovery, business spending, and U.S. dollar appreciation (as well as the resulting decline in exports).

4. Alternatives to fixed-income investments may carry unintended risks.

To avoid the threat of rising interest rates, some investors may be tempted to reallocate assets from bonds to income-generating investments such as high-dividend stocks or real estate investment trusts (REITs). While these substitute investments can offer attractive returns and diversification, they have their own sets of risks. Whats more, some have also benefited from the low interest-rate environment and may suffer sharp losses when the Feds asset purchases end.

Other income-generating options may be more prudent. These include investments in direct commercial real estate (if available) or guaranteed fixed annuities that may offer a degree of protection from rising rates. Even so, the benefits and risks of such alternatives are not identical to the characteristics of typical bond holdings. Investors need to consider whether and to what extent they should adjust their fixed-income allocations using these or other types of assets.

Stay focused on your strategy

Despite bonds vulnerability to rising interest rates, we believe fixed-income investments will continue to play a vital role in most peoples portfolios, if managed effectively. That means sticking to a long-term investment plan and not trying to time the rise and fall of interest rates, staying diversified across various types of securities, duration exposures and credit quality, managing with agility to keep a balanced portfolio, and treating alternatives to fixed-income with the appropriate caution given their own risks.

This material is for informational purposes only and should not be regarded as a recommendation or an offer to buy or sell any product or service to which this information may relate. Certain products and services may not be available to all entities or persons. Past performance does not guarantee future results

Investments in fixed-income securities are not guaranteed and are subject to interest rate, inflation, and credit risks.

TIAA-CREF Asset Management provides investment advice and portfolio management services to the TIAA-CREF group of companies through the following entities: Teachers Advisors, Inc. TIAA-CREF Investment Management, LLC, and Teachers Insurance and Annuity Association (TIAA). Teachers Advisors, Inc. is a registered investment advisor and wholly owned subsidiary of Teachers Insurance and Annuity Association (TIAA).