• BofA sees positive returns even in a bond bear market
  • Treasuries decline as traders add to bets on Fed rate increase

While Treasuries traders spent this week sorting through a cacophony of communications from Federal Reserve officials hinting at the path of interest rates, Bank of America Corp. reached a conclusion that cuts through that noise.

Even if the Fed pulls the trigger on a rate hike, Treasuries will remain a winning bet, according to Ralf Preusser, the bank’s global head of rates strategy in London. That flies in the face of conventional wisdom that fixed-income investors will face losses if interest rates rise.

Preusser simulated a potential bear market in Treasuries by projecting a mirror image of the downward path of yields during the bond bull market of the past three decades. His model showed that even should rates rise, U.S. bonds would produce positive returns, with gains in income offsetting price changes. For long-run investors, at least, Preusser suggests the obsession with Fed talk may miss the point.

“Our results bury the myth that a rising rate environment would deliver severe losses for bond investors over multiple decades,” Preusser and his team wrote. “Portfolio rebalancing at rising rates soon starts to dominate, with income return generating total returns fairly quickly.”

Since the Fed’s liftoff from near zero last December, investors have been bracing for further hikes that have yet to arrive. Treasuries fell this week as hawkish statements from some Fed officials clashed with the more dovish tone of the minutes from the Federal Open Market Committee’s July meeting released Aug. 17. Traders see about a 51 percent probability of a rate increase by year-end, up from a 42 percent chance assigned a week earlier, according to futures data compiled by Bloomberg.

Coupon Reinvestment

Benchmark Treasury 10-year yields rose six basis points this week, or 0.06 percentage point, to 1.58 percent, according to Bloomberg Bond Trader data.

Christopher Sullivan, who oversees $2.3 billion as chief investment officer at United Nations Federal Credit Union in New York, said Preusser’s projections were more encouraging than may have been expected.

“What’s neat about this report is that they reversed it in time precisely, and the total returns don’t look bad under the reverse scenario,” Sullivan said. “Whereas today your coupon gets reinvested at a really low rate, in a higher interest-rate environment the coupon interest is reinvested in higher cash rates. That’s going to incrementally add to your coupon return.”

New York Fed President William Dudley on Aug. 16 warned investors that they’re underestimating the likelihood of increases in borrowing costs. San Francisco Fed President John Williams on Thursday said next month’s policy meeting was “in play” for an interest-rate hike, and that traders’ views on the path of rates may not be consistent with the Fed’s.

Investors will look to Janet Yellen’s appearance in Jackson Hole on Aug. 26 for the next indication of where policy makers stand.

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