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Count on bond math to balance income portfolios

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The views expressed in these posts are those of the authors and are current only through the date stated. These views are subject to change at any time based upon market or other conditions, and Eaton Vance disclaims any responsibility to update such views. These views may not be relied upon as investment advice and, because investment decisions for Eaton Vance are based on many factors, may not be relied upon as an indication of trading intent on behalf of any Eaton Vance strategy. The discussion herein is general in nature and is provided for informational purposes only. There is no guarantee as to its accuracy or completeness.

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      By Payson F. Swaffield, CFAChief Income Investment Officer, Eaton Vance Management

      Boston - After three strong quarters in 2019, what can the bond market do for an encore? That's the big question for income investors now. We believe the key to understanding potential scenarios for the rest of the year lies in basic bond math.

      Let's begin by looking at the dynamics at work. As concerns about global growth and the durability of the U.S. expansion took hold, safety was uppermost in the minds of investors. Since the beginning of this year, the yield on the 10-year U.S. Treasury tumbled 100 basis points (bps) to 1.69% on September 30,1 and the yield curve with the 2-year Treasury briefly inverted in August - a traditional leading indicator of recession.

      Income investors pivoted from sectors typically favored in a strong economy with rising rates - including floating rate, shorter duration and lower credit quality issues. Instead, they piled into longer duration, higher credit quality sectors expected to fare better in an environment of slower growth and falling rates.

      Benefiting the most from this pivot were investment-grade corporate bonds, followed by U.S. dollar-denominated emerging-markets debt:

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      The impact of lower rates and investors piling into newly favored sectors can be seen in the large yield drops across all income sectors over the first nine months of 2019:

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      Duration measures the sensitivity of a bond's price to changes in yield: The longer the duration of a bond, the more its price will change with each tick in yield. So as rates fall, the price of a bond with longer duration rises more than the price of a bond with shorter duration. That's why longer duration bonds became so appealing when interest rates moved south during the year.

      Duration's downside

      While longer duration is an investor's friend when rates fall, it can become the enemy when rates rise. As indicated by their long duration, those bonds that gained the most as rates moved down have more sensitivity to interest rates - in other words, greater risk of falling prices if and when rates start to move up again.

      Duration isn't a static measure, however. For the sectors highlighted in the table above, the drop in rates caused duration to lengthen. In the investment-grade debt sector, for example, duration extended from 7.1 years to 7.8 years - making the prices of these bonds even more sensitive to rising rates.

      In other sectors where issues tend to be callable - meaning that borrowers can redeem the bonds before their stated maturities - duration shortened as rates dropped. For example, the duration of mortgage-backed securities (MBS) shortened by 2.0 years. As lending rates drop, homeowners have more incentive to refinance with lower-rate mortgages - in effect, calling their original higher-rate mortgages before maturity. That shortens the duration of MBS, making them less sensitive to rising rates.

      High-yield and municipal bonds each have call features. Investors in these sectors know that when rates fall enough, it makes sense for issuers to refinance. So they price the bonds to reflect a shorter effective maturity - shortening duration and limiting the risk of prices falling when interest rates rise.

      Bottom line: As this analysis suggests, investors may be well served by balanced income portfolios that reduce overall risk under alternative interest rate scenarios. These portfolios would be diversified to include sectors with shorter duration and with historically attractive credit spreads, such as floating-rate loans and high-quality MBS in the current environment.