The US bond market playbook: Diversification, risk control, and patience

28 Oct 2015

By Paul A. Matlack
Senior Vice President, Senior Portfolio Manager, Fixed Income Strategist, Delaware Investments(part of the Macquarie Group)

Many bond investors today are wading through a slurry of trepidation. They are at once frustrated, anxious, and confused: frustrated with the exceptionally low yields on their bond investments, anxious about the potential effects of rising rates on the value of those investments, and confused about the state of Federal Reserve policy and the seemingly endless delay in raising rates. So what exactly is transpiring, and how should bond allocations be positioned? 

Let’s begin with a short backgrounder on the bond market. As a starting point, it’s worth recognizing that there is no singular, all-encompassing bond market in the United States. There are at least five distinct venues, each with unique characteristics and risks. At the front of the pack is the U.S. Treasury bond market, with bonds ranging in maturity from mere days to 30 years. The yields on these securities are what we refer to when we talk about the yield curve (and more generically when we discuss interest rates). Given that Treasury securities are backed by the U.S. government, they carry little credit risk. Next in line is the investment grade corporate market, followed by the below-investment-grade (high yield) corporate market, the mortgage-backed market, and the municipal bond market. 

Each of these markets has several subsectors and varying degrees of credit risk, each of which trades at a so-called yield premium to the Treasury market. (This premium compensates investors for the degree of default risk that these securities bear, particularly when compared to Treasurys.) In each market, yield premiums can widen when investors become concerned about credit trends, and they can narrow when credit quality appears to be improving. Consequently, unlike the Treasury market (which only moves in response to interest rates), each of these four subsectors has two value drivers: changes in interest rates, and changes in yield spreads relative to Treasurys. This brings us to recent bond market performance and our outlook going forward. 

The tyranny of bond math 

The two value drivers mentioned above have been working in concert to deliver strong fixed income returns in recent years. First of all, interest rates (as denoted by Treasury yields) have been on a downward track for 30 years, with the 10-year Treasury yield falling from north of 15% in 1981 to just 2% at the time of this writing (see Chart 1). This has created a significant tailwind for both Treasury returns and all of the subsectors that trade in relation to Treasurys (as listed above). 

Chart 1. A steady decline in 10-year Treasury yields

Data: U.S. Federal Reserve. Daily observations.

All charts shown are for comparison purposes only. 

Second, and more recently, the 2008 financial crisis prompted investors to jettison their riskier bond assets and pile into safe-haven Treasurys. This had the effect of driving up Treasury prices (and their yields down), and driving down prices for the other bond sectors (and their yields up). The panic was so intense that the prices of high yield corporate bonds fell from 102 cents on the dollar to just 55 cents in December 2008, driving their yields to nearly 23%, or 21 full percentage points higher than comparable-maturity Treasurys. Today, the average high yield bond trades at 95 cents on the dollar and yields 7.6% (see Chart 2), resulting in a yield spread over Treasurys of 6.22 percentage points. This equates to a 13.4% annualized total return since December 2008.

 Chart 2. The effects of risk appetite on high yield corporate bonds

Data: BofA Merrill Lynch, via Federal Reserve Bank of St. Louis. Daily observations.

All charts shown are for comparison purposes only. 

Now the bad news: With interest rates at 60-year lows and with yield spreads for all sectors at or below long-term averages, these two drivers of bond market returns seem to have run their course. This is the tyranny of bond math, and it means returns going forward could be muted relative to prior years and should consist largely of coupon income. Which brings us to the Federal Reserve. 

What about the effects of monetary policy? 

The Fed is (and has been) anxious to begin normalizing its extraordinarily accommodative monetary policy, which would mean slowly unwinding (or selling back into the market) roughly $4 trillion in holdings of Treasurys and mortgages as well as lifting the federal funds rate, which at 0–0.25% is effectively bottomed out, as shown in Chart 3. (A negative federal funds rate is a possible — but unlikely — policy direction.) While the Fed’s balance sheet is likely to remain static for now, Fed officials will likely begin the process of normalizing the federal funds rate as soon as they are satisfied that markets are showing the right combination of (1) economic growth and stronger labor markets in the U.S., and (2) a measure of economic stability around the world. We believe normalizing is unlikely to entail a significant boost to the federal funds rate. More than likely, it’ll be a gradual and incremental series of small increases that may play out over several years.

 Chart 3. Federal funds rate: lower for longer

Data: U.S. Federal Reserve

All charts shown are for comparison purposes only. 

Unfortunately, during the last year, the Fed has been confronted with unacceptably low economic growth in the U.S., distressingly low inflation, and signs of slowing growth in places like China, emerging-market economies, and Europe. This means that the Fed is on hold for now, and while a rate bump is possible in December, it appears increasingly unlikely.

Ironically, investors have been fretful that the Fed will wait too long to initiate rate hikes, thus risking rising inflation and an overheated economy. But now the Fed appears to be facing a different dilemma: With growth slowing around the world, should it risk a rate increase now, possibly triggering even slower U.S. growth (and by extension slower global growth), or should it leave the federal funds rate at 0–0.25% and risk depriving itself of a key tool to stimulate growth should it need to do so in the future? 

Investment ramifications 

Given the deteriorating global growth dynamics described above, and the groundswell in downside risks to the U.S. economy, we are not overly concerned about an imminent or significant increase in interest rates. But we are concerned about this scenario: The decline in capital appreciation potential described earlier means that returns across fixed income sectors could consist largely of income, and opportunities for capital appreciation (as well as capital preservation) will require tactical dexterity. With such considerations in mind, we currently favor diversified, higher-quality portfolios that possess:

  • a tilt toward intermediate duration
  • a concentration in domestic fixed income sectors
  • a bias toward higher-quality credit, mortgage-backed securities, and Treasurys. 

While yields remain frustratingly low overall, we believe reaching for yield now (which would mean creeping out further on the risk-reward spectrum) poses unnecessary risk exposure for investors who look to their bond allocations for relative stability. In addition to resisting the urge to take on unwarranted risk for the sake of extra yield, we believe successful bond investors should employ patience. A patient approach provides the opportunity for investors to see how Fed policy and the global economic picture will sort themselves out.

The views expressed represent the Manager's assessment of the market environment as of October 2015 and should not be considered a recommendation to buy, hold, or sell any security, and should not be relied on as research or investment advice. Views are subject to change without notice and may not reflect the Manager's views.


Investing involves risk, including the possible loss of principal. 

Past performance does not guarantee future results.