Legg Mason Global Asset Management
March 02, 2017
A leading global investment company with specialized expertise in equities, fixed income, and alternatives.

A Look Back at History: Rising Rates and the Bond Market

Overall, fixed income delivered positive results during the past three Federal Reserve rate tightening cycles.

With the Federal Reserve (Fed) having increased its target rate in December 2015 and again in December 2016, investors are wondering how may hikes to expect in 2017. The Fed’s statement following its December 2016 FOMC meeting suggested three hikes could be in store for next year.

Of course, much will depend on how the economy actually performs. Consider that after increasing rates in December 2015, the Fed initially implied that four rate hikes were possible in 2016 -- a prediction that did not pan out.

Still, if we are actually on the cusp of an extended Fed tightening cycle, fixed-income investors are certainly interested in how it could impact their portfolios. A look back at history provides some perspective for investors that suggests there may be benefits to staying put and “riding out” the cycle, instead of rushing for the exits or pursuing a market-timing strategy.

Surprising performance

Indeed, an analysis of representative index performance provides interesting insight into what investors might expect when interest rates are rising.

In the three most recent Fed tightening cycles (1994–1995, 1999-2000, 2004–2006), a positive total return resulted as coupon interest payments more than offset price declines.1

More importantly, index performance was solid across the entire interest rate cycle (defined here as the 12 months preceding the onset of Fed tightening to 12 months after the last rate hike).

Performance was negative on just a few occasions during the most challenging part of the cycle: from the low in the benchmark 10-year Treasury yield to its high.

The active advantage

In our opinion, an actively managed bond approach offers the potential for a better return than passive index investing. So, while index performance was positive during recent Fed tightening cycles, professional management of diversified fixed income investments could offer several important potential advantages:

  • A degree of diversification that most investors in individual bonds cannot attain on their own.
  • The ability to play defense when interest rates are rising, by managing duration, something that a passive index cannot do.
  • The expertise to take advantage of values created in all sectors of the market through effective security analysis and sector rotation, potentially enhancing total return.

Periods of rising interest rates are a normal part of bond investing, but that doesn’t mean that they don’t create anxiety. However, before making any impulsive moves out of fixed income, you should carefully consider the risks involved in attempting to time moves in and out of the market, including the potential for unwanted taxable events.

For more detail on how bond markets reacted during past tightening cycles and the potential benefits of “riding it out,” read the full report.

Legg Mason
Thought Leadership
This document refl ects the opinions, views and analysis of Western Asset
regarding conditions in the economy and markets, which are subject to
change, and may differ from those of other professional investment managers.
All investments involve risk, including possible loss of principal.
1
Performance measured by the Bloomberg Barclays 1– 3 Month Treasury Bill Index, the Bloomberg Barclays
Intermediate Treasury Index, the Bloomberg Barclays Intermediate U.S. Government/Credit Index and the
Bloomberg Barclays U.S. Aggregate Index. Indexes are unmanaged, and not available for direct investment.
Index returns do not include fees or sales charges.
Please refer to page 7 for a Glossary of Terms.
This material is only for distribution in those countries and to those recipients listed.
Please refer to the disclosure information on the fi nal page.
A look back at history:
RISING R ATES AND
THE BOND MARKE T
Fixed income’s performance during past interest rate
cycles off ers valuable context for investors now.
Historically, the income that bonds produce has off set
the impact of rising interest rates on total return.
Overall, fi xed income delivered positive results during
the past three Federal Reserve rate tightening cycles.
1
History suggests there may be benefi ts to staying put and
“riding out” the cycle, instead of rushing for the exits or
pursuing a market-timing strategy.
Active management may benefi t investors by providing the
fl exibility to play defense when rates are rising, as well as
the expertise to capture value created amid price volatility.
JAN
2017
IN THE U.S. – INVESTMENT PRODUCTS: NOT FDIC INSURED • NO BANK GUAR ANTEE • MAY LOSE VALUE
The active advantage
In our opinion, an actively managed
bond approach offers the potential
for a better return than passive
index investing. So, while index
performance was positive during recent
Fed tightening cycles, professional
management of diversified fixed-
income investments could offer several
important potential advantages:
A degree of diversification that most
investors in individual bonds cannot
attain on their own.
The ability to play defense when
interest rates are rising, by managing
duration, something that a passive
index cannot do.
The expertise to take advantage of
values created in all sectors of the
market through effective security
analysis and sector rotation,
potentially enhancing total return.
Awaiting the next move
It’s been said that the only guarantee
in bond investing is that interest rates
will rise and interest rates will fall.
Given very low short-term interest
rates, the only direction the Fed
can really move is higher.
With the Fed having increased its
target rate twice since December 2015,
investors are closely monitoring to
see if the Fed delivers on its current
projection of 2 to 3 rate hikes in 2017.
2
Performance measured by the Bloomberg Barclays
Intermediate Treasury Index, the Bloomberg Barclays
Intermediate U.S. Government/Credit Index and the Bloomberg Barclays
U.S. Aggregate
Index. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges.
Surprising performance
An analysis of representative index
performance provides interesting
insight into what investors might
expect when interest rates are rising.
In the three most recent Fed
tightening cycles (1994 –1995,
1999–2000, 2004–2006), a positive
total return resulted as coupon
interest payments more than
offset price declines.
2
More importantly, index performance
was solid across the entire interest
rate cycle (defined here as the 12
months preceding the onset of Fed
tightening to 12 months after the
last rate hike).
Performance was negative on just
a few occasions during the most
challenging part of the cycle: from
the low in the benchmark 10-year
Treasury yield to its high.
3
Reflects performance from the month when 10-year Treasury yields were at a low for the cycle through the month when they peaked for the cycle.
4
From June 2004 through June 2006, the months when the Fed was actively raising interest rates, the Bloomberg Barclays
1–3 Month T-bill Index returned 6.1%, compared with 3.7% for the
Bloomberg Barclays Intermedia
te Treasury Index, 4.6% for the Bloomberg Barclays
Intermediate Government/Credit Index and 5.9% for the Bloomberg Barclays
U.S. Aggregate Index. From June 2003 to
June 2007, the Bloomberg Barclays
1–3 Month T-bill Index returned 12.5% compared with 8.6% for the Bloomberg Barclays
Intermediate Treasury Index, 10.6% for the Bloomberg Barclays
Intermediate
Government/Credit Index, and 12.8% for the Bloomberg Barclays
U.S. Aggregate Index.
A look back at past periods of Federal Reserve tightening provides valuable insight
into what investors might expect in the next cycle.
The 2004 – 2006 Federal Reserve tightening cycle
Rates rose...
Source:
Bloomberg.
Past performance is no guarantee of future results.
This information is provided for illustrative purposes only and does not reflect the
performance of an actual investment. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges.
The Fed raised the federal
funds rate from 1% to
5.25% between June 2004
and June 2006.
The 10-year Treasury yield
oscillated in a fairly tight
range between 4.58%
when the Fed started
raising interest rates and
5.13% when it stopped.
Positive total returns during
the Fed’s tightening cycle.
Positive total returns from
the low to high in the
10-year Treasury yield.
“Riding it out” resulted in
solid returns, with the most
diversified index producing
the best results.
4
A LOOK BACK
AT PAST CYCLES
...And the results were...
Source:
Bloomberg Barclays
.
Past performance is no guarantee of future results.
Treasury bills represented by the Bloomberg Barclays
1–3
Month Treasury Bill Index; Intermediate Treasuries represented by the Bloomberg Barclays
Intermediate Treasury Index; Intermediate Govt/Credit
represented by the Bloomberg Barclays
Intermediate U.S. Government/Credit Index; and U.S. Aggregate represented by the Bloomberg Barclays
U.S. Aggregate Index. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.
Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges.
Federal funds rate vs. 10-year Treasury note yield (%)
Yield
0
1
2
3
4
5
6
Federal funds rate
10-year Treasury rate
MAY
2004
MAY
2005
JAN
2005
JAN
2006
SEP
2006
SEP
2004
SEP
2005
MAY
2006
Low in 10-yr Treasury yield
High in 10-yr Treasury yield
Fed begins raising rates June 2004
Last Fed rate hike June 2006
Comparative total returns (%)
Cumulative total return
0
4
6
8
10
12
14
Treasury bills
Intermediate gov/credit
Fed tightening cycle
6/30/0
4–
6/30/06
10-yr yield low to high
3
6/30/0
3–
6/30/06
Riding it out
6/30/0
3–
6/29/07
Intermediate Treasuries
U.S. aggregate
2
6 .1
3.7
4.6
5.9
7. 0
3 .1
4.5
6.3
12.5
8.6
10.6
12.8
The 1999–2000 Federal reserve tightening cycle
Rates rose...
Source: Bloomberg.
Past performance is no guarantee of future results.
This information is provided for illustrative purposes only and does
not reflect the performance of an actual investment. Indexes are unmanaged, and not available for direct investment. Index returns do not include
fees or sales charges.
...And the results were...
Source: Bloomberg Barclays.
Past performance is no guarantee of future results.
Treasury bills represented by the Bloomberg Barclays
1 – 3 Month Treasury Bill Index; Intermediate Treasuries represented by the Bloomberg Barclays Intermediate Treasury Index; Intermediate
Govt/Credit represented by the Bloomberg Barclays Intermediate U.S. Government/Credit Index; and U.S. Aggregate represented by the
Bloomberg Barclays U.S. Aggregate Index. This information is provided for illustrative purposes only and does not reflect the performance
of an actual investment. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges.
Federal funds rate vs. 10-year Treasury note yield (%)
Yield
0
4
8
2
Federal funds rate
10-year Treasury rate
SEP
1998
6
MAY
2000
JAN
1999
MAR
1999
SEP
1999
JAN
2000
Low in 10-yr Treasury yield
High in 10-yr Treasury yield
Last Fed rate hike May 2000
Fed begins raising rates June 1999
Comparative total returns (%)
Cumulative total return
-5
10
25
5
20
Fed tightening cycle
6/30/9
9–
5/31/00
10-yr yield low to high
5
10/30/9
8–
1/31/00
Riding it out
6/30/9
8–
6/30/01
Treasury bills
Intermediate gov/credit
Intermediate Treasuries
U.S. aggregate
15
0
4.9
3 .1
2.4
2.4
4.9
16.7
20.2
20.6
20.0
0.1
0.4
-0.3
5
Reflects performance from the month when 10-year Treasury yields were at a low for the cycle through the month when they peaked for the cycle.
6
F
rom June 1999 through May 2000, the months when the Fed was actively raising interest rates, the Bloomberg Barclays
1–3 Month Treasury Bill Index returned 4.9%, the Bloomberg Barclays
Intermediate Treasury Index returned 3.1%, the Bloomberg Barclays
Intermediate Government/Credit returned 2.4% and the Bloomberg Barclays
U.S. Aggregate Index returned 2.4%. From October 1998
through January 2000, the period when the 10-year yield rose by 224 basis points, the Bloomberg Barclays
1-3 Month Treasury Bill Index returned 6%, the Bloomberg Barclays
Intermediate Treasury Index
returned 0.1%, the Bloomberg Barclays
Intermediate Government/Credit returned 0.4% and the Bloomberg Barclays
U.S. Aggregate Index returned -0.3%. From June 1998 (a year before the Fed began
tightening) to June 2001 (a year after the Fed stopped tightening), the Bloomberg Barclays
1–3 Month Treasury Bill Index returned 16.7%, the Bloomberg Barclays
Intermediate Treasury Index returned
20.2%, the Bloomberg Barclays
Intermediate Government/Credit returned 20.6% and the Bloomberg Barclays
U.S. Aggregate Index returned 20%.
The Fed raised the federal
funds rate from 4.75% to
6.5% between June 1999
and May 2000.
The 10-year Treasury yield
increased from a low of
4.42% in October 1998
to a peak of 6.66% in
January 2000.
Positive total returns during
the Fed’s tightening cycle.
Mixed performance from
the low to high in the
10-year Treasury yield.
“Riding it out” resulted in
positive returns across the
entire interest rate cycle.
6
The 1994–1995 Federal Reserve tightening cycle
Rates rose...
Source:
Bloomberg
.
Past performance is no guarantee of future results.
This information is provided for illustrative purposes only and does
not reflect the performance of an actual investment. Indexes are unmanaged, and not available for direct investment. Index returns do not include
fees or sales charges.
...And the results were...
Source: Bloomberg Barclays.
Past performance is no guarantee of future results.
Treasury bills represented by the Bloomberg Barclays
1– 3 Month Treasury Bill Index; Intermediate Treasuries represented by the Bloomberg Barclays Intermediate Treasury Index; Intermediate
Govt/Credit represented by the Bloomberg Barclays Intermediate U.S. Government/Credit Index; and U.S. Aggregate represented by the
Bloomberg Barclays U.S. Aggregate Index. This information is provided for illustrative purposes only and does not reflect the performance
of an actual investment. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges.
The Fed raised the federal
funds rate from 3% to 6%
between February 1994
and February 1995.
The 10-year Treasury yield
increased from a low of
5.38% in September 1993
to a peak of 7.90% in
November 1994.
Positive total returns during
the Fed’s tightening cycle.
Modest declines from the
low to high in the 10-year
Treasury yield.
“Riding it out” resulted
in solid returns, with
more diversified indexes
producing better results.
8
7
Reflects performance from the month when 10-year Treasury yields were at a low for the cycle through the month when they peaked for the cycle.
8
From February 1994 to February 1995, the period when the Fed was actively raising interest rates, the Bloomberg Barclays
1-3 Month Treasury Bill Index returned 4.6%, the Bloomberg Barclays
Intermediate
Treasury Index returned 2.2%, the Bloomberg Barclays
Intermediate Government/Credit returned 2.2% and the Bloomberg Barclays
U.S. Aggregate Index returned 1.8%. From September 30, 1993 to
November 30, 1994, the period from the low in 10-year Treasury yields to the peak in 10-year Treasury yields, the Bloomberg Barclays
1–3 Month Treasury Bill Index returned 4.4%, the Bloomberg Barclays
Intermediate Treasury Index returned -1.9%, the Bloomberg Barclays
Intermediate Government/Credit Index returned -2.1% and the Bloomberg Barclays
U.S. Aggregate Index returned -3.5%. From February
1993 to February 1996, the Bloomberg Barclays
1–3 Month T-bill Index returned 11.5%, compared with 17.4% for the Bloomberg Barclays
Intermediate Treasury Index. The more diversified Bloomberg Barclays
Intermediate Government/Credit Index and Bloomberg Barclays
U.S. Aggregate Index did even better, up 18.44% and 20.41%, respectively.
Federal funds rate vs. 10-year Treasury note yield (%)
Yield
0
6
10
2
Federal funds rate
10-year Treasury rate
SEP
1993
8
JAN
1995
JAN
1994
MAY
1994
SEP
1994
Low in 10-yr Treasury yield
High in 10-yr Treasury yield
Last Fed rate hike Feb 1995
Fed begins raising rates Feb 1994
4
Comparative total returns (%)
Cumulative total return
-5
10
25
5
20
Fed tightening cycle
2/28/9
4–
2/28/95
10-yr yield low to high
7
9/30/9
3 –1
1/30/94
Riding it out
2/26/9
3–
2/29/96
Treasury bills
Intermediate gov/credit
Intermediate Treasuries
U.S. aggregate
15
0
4.6
2.2
2.2
1.8
4.4
11. 5
17. 4
18.4
20.4
-1.9
-2.1
-3.5
Periods of rising interest rates are a normal part of bond investing, but that doesn’t
mean that they don’t create anxiety. However, before making any impulsive moves out
of fixed income, you should carefully consider the risks involved in attempting to time
moves in and out of the market, including the potential for unwanted taxable events.
As you can see from the examples from the previous pages, “riding it out” has made
sense in the past.
Yet, these only reflect the performance of passive indexes.
While active management and diversified approaches do not
guarantee superior or positive performance, we firmly believe
they provide the following potential performance-enhancing
benefits that are not accessible with passive investments:
Experience
Professional management offers access to lessons learned
during past cycles.
Diversification
Most individual investors do not have the buying power
or the access to the issues necessary to properly diversify
across multiple issuers, sectors, industry groups, countries
and currencies. Diversification does not guarantee a profit
or protect against loss.
THE ACTIVE
A DVANTAGE
Research and analysis
Actively managed approaches give individual investors
access to individual security analysis and sector rotation
skills that can enhance the opportunity for growth through
a focus on total return instead of just yield.
Flexibility
Professional management provides the ability to quickly
respond to opportunities in the market that can arise
abruptly for many different reasons.
Risk management
Including duration management, yield curve positioning
and ongoing monitoring and portfolio restructuring based
on changing conditions.
Investment risks
The opinions and views expressed herein are not intended
to be relied upon as a prediction or forecast of actual future
events or performance, or a guarantee of future results, or
investment advice.
Fixed income securities are subject to interest rate and credit
risk, which is a possibility that the issuer of a security will
be unable to make interest payments and repay the principal
on its debt. As interest rates rise, the price of fixed income
securities falls.
Diversification does not assure against market loss.
Outperformance does not imply positive results.
Active Management does not ensure gains or protect against
market declines.
There is no guarantee objectives will be met.
U.S. Treasuries are direct debt obligations issued and backed
by the “full faith and credit” of the U.S. government. The U.S.
government guarantees the principal and interest payments
on U.S. Treasuries when the securities are held to maturity.
Unlike U.S. Treasury securities, debt securities issued by the
federal agencies and instrumentalities and related investments
may or may not be backed by the full faith and credit of the
U.S. government. Even when the U.S. government guarantees
principal and interest payments on securities, this guarantee
does not apply to losses resulting from declines in the market
value of these securities.
About Western Asset
Western Asset Management is one of the world’s leading
fixed income managers. With a focus on long-term
fundamental value investing that employs a top-down and
bottom-up approach, the firm has nine offices around the
globe and deep experience across the range of fixed income
sectors. Founded in 1971, Western Asset has been recognized
for an approach emphasizing team management and intensive
proprietary research, supported by robust risk management.
DEFINITIONS:
The
Bloomberg Barclays 1–3 Month Treasury Bill Index
is the 1–3 months component of the U.S. Treasury bills index.
Indexes are unmanaged, and not available for direct investment.
Index returns do not include fees or sales charges.
The
Bloomberg Barclays Intermediate Treasury Index
is
the intermediate component of the U.S. Treasury index. Indexes
are unmanaged, and not available for direct investment.
Index returns do not include fees or sales charges.
The
Bloomberg Barclays Intermediate Government/
Credit Index
is a market value-weighted performance
benchmark for government and corporate fixed-rate debt issues
(rated Baa/BBB or higher) with maturities between one and
10 years. Indexes are unmanaged, and not available for direct
investment. Index returns do not include fees or sales charges.
The
Bloomberg Barclays U.S. Aggregate Index
is a
broad-based bond index consisting of government, corporate,
mortgage and asset-backed issues rated investment grade or
higher and having at least one year to maturity. Indexes are
unmanaged, and not available for direct investment. Index
returns do not include fees or sales charges.
A
basis point
is one one-hundredth (1/100 or 0.01)
of one percent.
Duration
is the measure of the price sensitivity of a fixed-
income security to an interest rate change of 100 basis points.
Calculation is based on the weighted average of the present
values for all cash flows.
The U.S.
Federal Reserve
, or “
Fed
,” is responsible for the
formulation of a policy designed to promote economic growth,
full employment, stable prices, and a sustainable pattern of
international trade and payments.
The
federal funds rate
is the interest rate that banks with
excess reserves at a U.S. Federal Reserve district bank charge
other banks that need vernight loans.
Gross domestic product,
or
GDP
, is the total market
value of all final goods and services produced in a country
in a given year.
Maturity
refers to the date on which the principal is required
to be paid on a bond.
Quantitative easing (QE)
refers to a monetary policy
implemented by a central bank in which it increases the
excess reserves of the banking system through the direct
purchase of debt securities.
A
Treasury bill
is a negotiable debt obligation issued by the
U.S. government and backed by its “full faith and credit,” and
which has a maturity of one year or less.
A
Treasury note
is a negotiable debt obligation issued by the
U.S. government and backed by its “full faith and credit,” and
which has a maturity of one to 10 years.
U.S. Treasuries
are direct debt obligations issued and
backed by the “full faith and credit” of the U.S. government.
The U.S. government guarantees the principal and interest
payments on U.S. Treasuries when the securities are held
to maturity. Unlike U.S. Treasury securities, debt securities
issued by the federal agencies and instrumentalities and
related investments may or may not be backed by the full
faith and credit of the U.S. government. Even when the U.S.
government guarantees principal and interest payments on
securities, this guarantee does not apply to losses resulting
from declines in the market value of these securities.
The
U.S. Treasury Department
is responsible for issuing
all Treasury bonds, notes and bills; it is responsible for the
revenue of the U.S. government.
The
yield curve
shows the relationship between yields
and maturity dates for a similar class of bonds.
*
As of September 30, 2016.
© 2017 Legg Mason Investor Services, LLC. Member FINRA, SIPC. Western Asset Management Company of Legg Mason, Inc. and
Legg Mason Investor Services, LLC and all entities mentioned above are subsidiaries of Legg Mason, Inc.
681913 MIPX013130 1/17
IMPORTANT INFORMATION:
All investments involve risk, including possible loss of principal.
The value of investments and the income from them can go down as well as up and investors may not get back the amounts originally
invested, and can be affected by changes in interest rates, in exchange rates, general market conditions, political, social and economic
developments and other variable factors. Investment involves risks including but not limited to, possible delays in payments and loss
of income or capital. Neither Legg Mason nor any of its affiliates guarantees any rate of return or the return of capital invested.
Equity securities are subject to price fluctuation and possible loss of principal. Fixed-income securities involve interest rate, credit,
inflation and reinvestment risks; and possible loss of principal. As interest rates rise, the value of fixed income securities falls.
International investments are subject to special risks including currency fluctuations, social, economic and political uncertainties,
which could increase volatility. These risks are magnified in emerging markets.
Commodities and currencies contain heightened risk that include market, political, regulatory, and natural conditions and may not
be suitable for all investors.
Past performance is no guarantee of future results. Please note that an investor cannot invest directly in an index.
Unmanaged index returns do not reflect any fees, expenses or sales charges.
The opinions and views expressed herein are not intended to be relied upon as a prediction or forecast of actual future events or
performance, guarantee of future results, recommendations or advice. Statements made in this material are not intended as buy or
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