Various market performance charts

Fed's Rate-Hike Dance Gives Bond Investors Tired Feet

Various market performance charts

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Bond mutual funds were trotting along rather quietly in August up until Fed Chair Janet Yellen announced at the end of the month that the odds of a rate hike had strengthened.

As a result, August turned out to be the worst month for Treasuries since the summer of 2015.

General U.S. Treasury funds sank 0.81%, while U.S. Government funds declined 0.42%. Both are still up 9.52% and 4.52% so far this year, according to preliminary Lipper Inc. performance figures.

Intermediate U.S. Government funds gave up 0.41%, while short ones fell 0.13%. They're up a respective 3.34% and 0.95% year to date. Short U.S. Treasury funds declined 0.11%, but are up 1.29% year to date.

On the corporate front, core bond funds were off 0.2%, while short investment-grade debt mutual funds picked up 0.45%. Funds rated A and BBB climbed 0.13% and 0.26%, respectively.

However, data released in early September pointed to slower-than-expected U.S. employment growth in August after two robust summer months, dampening the case of a September rate increase.

"What we expect for the remainder of the year would be 'lower for longer,' " said John Donovan, head of fixed income and trading at U.S. Trust, Bank of America Private Wealth Management.

Riskier assets performed better in August. High-yield bond funds jumped 1.81%, bringing their yearly gains to 10.88%, topping the average S&P 500 fund's 7.35% and the U.S. diversified stock funds' 6.09%.

Emerging-market hard-currency debt funds also did well, amassing a 1.55% return for the month and 13.07% year to date. Local-currency ones trailed with a 0.2% gain, though they're ahead of the hard-currency ones for the year, with a 13.31% return.

Some fixed-income fund managers still expect the Fed to hike rates by year-end, most likely in December. The election will also keep the markets on edge.

"If we do get a bout of volatility around election time and the data are not great, that may lead to a delay (in raising rates)," said Ben Emons, managing director and co-manager of the $370 million Leader Capital Short Term Bond Fund ( LCCMX ). "Forty-five percent probability (of a December hike) is not a high probability. It may be enough to make it happen, but it's not high either."

Analysts also expect the yield curve to continue to flatten as short-term rates go up.

U.S. Trust's Donovan still sees some value in investment grade, such as banking and industrials. He warns to be cautious in high yield, especially in the energy and commodity sectors as the rally has already occurred. The key is to be up in quality.

Bank loans offer some benefits to investors as they carry less interest-rate risk and have less exposure to the energy sector. They are usually higher quality than the high-yield market. But investors need to keep in mind that it may take the Fed to tighten two or three times before the coupon will actually reset to a higher rate, Donovan warns.

Steve Huber, portfolio manager in the fixed-income division at T. Rowe Price and manager of the $33.8 million T. Rowe Price Global Multi-Sector Bond Fund ( PRSNX ), also likes agency mortgages, primarily for liquidity reasons.

"The risk that you have is that interest-rate volatility picks up, and that will cause some of the prepayment options to change and they'd have a sell-off there. But they're higher quality, more liquid, and the sell-off that you would tend to see would be much less than you could see in some of the higher-risk credit sectors," he said. "So mortgage-backed securities are a good place to hide out. You just have to watch volatility and watch where interest rates are going."

In the nontaxable bond universe, municipal bond funds provided positive, though more muted, returns in August. But it was their 14th straight month of positive returns, marking 46 straight weeks of positive fund flows.

High-yield muni funds were ahead of the pack with a 0.41% and 6.52% return for August and year to date, respectively. General and insured muni debt funds also did all right, advancing 0.23% and 4.46% during the respective periods.

"I think we've turned the corner a little bit," said Peter Hayes, head of BlackRock's Municipal Bonds Group and portfolio manager of the $5.1 billion BlackRock Strategic Municipal Opportunities Fund ( MAMTX ). "First half of the year, we had a lot of momentum. Going forward, it's going to be more about maximizing your income."

He's not too worried about rates going significantly higher and has taken a bit of a laddered instead of a barbell approach in muni investing.

He still sees quite a bit of demand for new issue supply in the credit area, which offers some yield. Sectors he likes are health care, transportation and high yield.

The key message to fixed-income investors is to keep their portfolio liquid and diversified. T. Rowe Price's Huber warns against taking on too much risk to get more yield.

"You can collect the coupon for a while, but when the risk comes, markets can sell off pretty quickly," Huber said. "In some of the credit markets liquidity can dry up quickly also, which tends to make the price movements more pronounced. So I am exercising caution on risk and lower quality."


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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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