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By Dave Sekera, CFA| 1-13-2017 4:00 PM

Prepare for Interest Rates to Rise

Bonds had a tough fourth quarter as rates rose, and there is room for both short- and long-term rates to head higher in 2017

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Dave Sekera: Fixed-income securities generally performed poorly in the fourth quarter of 2016 as rising interest rates pushed down bond prices faster than yield carry could offset those losses. For example, the Morningstar Core Bond Index, our broadest measure of the fixed-income universe, declined by 3.06% in the fourth quarter, and the Morningstar Corporate Bond Index, our proxy for the investment-grade corporate bond market, declined 2.93%.

However, even after accounting for the losses in the fourth quarter, the fixed-income market performed well in 2016. For example, the core bond index rose 2.64%, and our corporate bond index rose 5.81% last year. The excess return in the corporate bond index was generated by tightening corporate credit spreads, as the average credit spread of our index tightened by 40 basis points over the course of last year.

Looking forward, even though interest rates rose sharply in the fourth quarter, interest rates may still have further to rise over the next year. In the short end of the yield curve, based on the Federal Reserve's latest summary of economic projections, on average, the members are forecasting several additional hikes to the federal funds rate by the end of 2017.

Among long-term interest rates, Robert Johnson, Morningstar's director of economic research, is currently forecasting that long-term interest rates will continue to rise over 2017. His current forecast for the yield of the 10-year Treasury is to rise to approximately 3.50% by the end of this year.

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