(PUB) Investing 2015

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Bond investors continue to fret about the potential
timing and magnitude of interest-rate hikes from
the Federal Reserve. The general consensus coming
into 2015 was for liftoff in June, but weaker-
than-expected economic data shifted expectations
to a later rate hike. At its September meeting,
the Fed kept rates unchanged and, once rates lift off,
many expect a very gradual move toward normal-
ized interest rates. While it’s difficult to predict how
funds will fare in the face of rising rates, certain
Morningstar Categories of funds are likely to do better
than others.
Core Bond Funds
Morningstar categorizes core bond funds by duration—
short, intermediate, and long term. The Fed doesn’t
control the intermediate and long ends of the yield
curve, however, and markets have responded differ-
ently in past rounds of rate hikes. For example, during
the hikes from March 2004 to June 2006, the yield
curve significantly flattened; during the September
1993 to December 1994 hikes, the yield curve shifted
in a virtually parallel fashion. If the yield curve
steepens or shifts upward in a more or less parallel
fashion, long-term bond funds will underperform
short-term bond funds, perhaps significantly. But if
the yield curve flattens, which is not out of the
question given the troubles abroad that may continue
to push investors toward the safe haven of U.S.
Treasury bonds of all maturities, shorter-term bond
funds may not provide as much of a cushion
against rising rates.
Corporate-Credit Bond Funds
Because the economy is healthy, credit-sensitive funds
should perform better than funds that hold higher-
quality, longer-maturity bonds. These are funds in the
corporate, high-yield, and bank-loan categories.
Many investors have turned to bank loans, assuming
that floating-rate bank-loan coupons will rise
when rates rise. Bank loans do have less interest-rate
risk than many other types of bonds, but there’s
still credit risk. Furthermore, bank loans may act more
like short-duration, fixed-coupon bonds than
floating-rate securities when rates first rise because
of Libor floors. This sets a minimum payment if
the reference rate (Libor) falls below the specified
“floor.” With rates currently below most Libor
floors, bank-loan coupons may not rise with the
Fed’s first interest-rate hikes.
Global-Bond Funds
It’s generally expected that the eurozone and Japan
will rely on quantitative easing much longer than
the United States, delaying rate hikes overseas. But
the market for high-quality non-U.S. government
bonds can track U.S. Treasuries when investors seek
safe-haven assets. If the Fed delays the hike, it
may stoke fears of slowing global growth, and those
bonds could strengthen. And the dollar is likely
to weaken, which would boost issues denominated
in euros or yen.
Emerging-markets bonds face big challenges, as
those currencies have weakened against the
dollar, making debt loads more expensive. Further
delays in U.S. rate hikes may cause even more
damage as investors continue to flee. Local-currency
emerging-markets bonds, which have already been
hit harder than bonds denominated in U.S. dollars, are
likely to suffer more as investors dump riskier fare.
Municipal-Bond Funds
Municipal bonds, like corporate and government
bonds, are issued with a range of maturities, so dura-
tion dynamics are at play here. Importantly, muni
bonds are tax-advantaged, providing an additional
cushion during periods of rising rates. As interest
rates rise, the income component of a bond’s returns
helps buoy its total return as the bond’s price
drops—the higher the payout, the more it counters
a share price decline. The supply/demand story
for munis may also provide a boost. Muni bonds’ tax-
equivalent yields are high and in demand, and,
as interest rates rise, issuers are less likely to refinance
existing bonds, which may reduce the supply. K
Contact Cara Esser at
When the Fed Raises Rates
Income Strategist | Cara Esser