Making Sense of Bonds and Rising Rates

It is widely acknowledged that interest rates will rise this year from their current lows. Faced with the possibility of rising rates that could result in lower bond prices, many clients are asking if they should temporarily move out of fixed income to other asset classes.

We believe, in most cases, the answer is no. Fixed income, or bonds, have historically been viewed as a more stable source of investment returns than stocks. As a consequence, investors generally should expect lower long-term expected returns in exchange for this more stable return pattern.

Since the global financial crisis nearly a decade ago, interest rates globally have been gradually pushed lower and lower. The systematic lowering of interest rates by central banks has been an effort to re-ignite growth.

The risk of being wrong by investing too much in stocks could definitely cause more damage than staying invested in fixed income.

As interest rates drop, bonds increase in value. With increasing bond prices, yields on bonds fall. That’s because you’re getting the same amount of periodic interest payments on a bond that now costs you more to buy. Conversely, as interest rates rise, prices drop and yields increase. The extent to which bond values rise and fall with interest rate changes is largely a function of the amount of time left until the bond matures. A bond with a longer maturity would experience larger price changes.

With bond yields now being slight, and investors expecting a rising interest rate environment (falling bond prices) in the U.S., investors could be forgiven for wanting to briefly forego their bond portfolios in favor of investment strategies that seemingly are earning higher price returns today. So why should you keep bonds in your portfolio?

Rising rates are not all bad

For long-term fixed income investors, rising rates are not necessarily a bad thing.

The U.S. Federal Reserve Board has already indicated its desire to raise rates three times this year. These rate increases, and the market’s expectations for them, have already been priced into bonds today. This means intermediate- and long-term interest rates have already increased to help compensate investors for changes the Federal Reserve is expected to make to short-term interest rates.

To be sure, there may be initial losses from price declines. However, as bonds mature within a portfolio or fund, those proceeds are reinvested into other bonds at higher interest rates. Any short-term price declines are offset over time by the increasing yield from the bond portfolio. The length of time needed to recover from a rate shock is dependent on the size of the rate increase and the types of bonds you have in your portfolio.

The table below shows a hypothetical example of how interest rate shocks might impact the Bloomberg Barclays Aggregate Index. In the highlighted row, an immediate increase in intermediate-term interest rates of 0.50%, or 50 basis points, results in the one-year total return dropping from 2.6% to 0.4%. Not pleasant. But over three years, as higher coupon payments are reinvested, the index recovers to 2.2% annualized return, and by 10 years to a 2.8% annualized return.

SOURCE: PIMCO*

One thing about fixed income that many investors seem to get wrong when trying to predict bond returns is what interest rate to focus on, says my colleague Phil J. Kastenholz, a director of Investment Advisory and principal at Aspiriant. For example, the above chart is not focused on changes in the federal funds rate managed by the Federal Reserve. The yield of the Bloomberg Barclays US Aggregate Index is better represented by the seven- or 10-year Treasury bond yield. Each maturity date has its own market-driven interest rate which is called the yield curve.

“It isn’t as easy as saying, ‘The Fed is going to raise rates, therefore the prices of bonds will go down,’” Phil explains. “For example, 10-year bonds could see interest rates stay flat, or even go down, during a period of Fed interest rate increases.”

Why? Because expectations about future inflation and economic growth often exert more influence over long-term interest rates than Fed policy. Phil says this is exactly what happened from June 2004 through November 2006 when the federal funds rate increased by 4.25%, from 1% to 5.25%, and the 10-year Treasury yield stayed at 4.72%. While the changes the Fed make are important, it isn’t always easy to predict bond returns over the short-term based on the knowledge that the Fed is going to increase the federal funds rate.

The risk of being wrong

If history teaches us anything, it’s that no single asset class will be the best performer year-over-year. Investors should understand, and be comfortable with, the risk of being wrong when making changes to their investment plans based on short-term market developments.

The fourth quarter reminded us that bonds’ lower risk is not the same as no risk. There are periods of heightened volatility in fixed income, albeit less in frequency and magnitude when compared to equities. Drawdowns during the end of 2016 were about as bad as it gets for bond investors. Meanwhile, domestic stocks generally performed well during that period. But the risk of being wrong by investing too much in stocks could definitely cause more damage than staying invested in fixed income.

This recent period again shows why it’s important to remain diversified. Of course, the decision to move out of fixed income into more equities may work out well for you. However, this result can only be determined with hindsight a few years in the future when you can look back and assess the investment decisions you’ve made. Putting your financial goals at risk in the hope you are correct about a big change to your investment plan driven by recent performance is not a prudent investment strategy.

As value investors, we favor a measure of capital preservation rather than a portfolio solely focused on historical returns with little regard to potential loss. A portfolio constructed to avoid sizeable losses over time may occasionally experience some near-term drops. But a portfolio properly diversified between fixed income, equity and other strategies, in a prudent and disciplined fashion, can help you avoid some of those losses and be in a better position to take advantage of favorable investment conditions whenever and wherever they arise.

* Hypothetical example for illustrative purposes only. In this analysis, PIMCO has outlined hypothetical event scenarios which, in theory, would impact the portfolio returns as illustrated. No representation is being made that these scenarios are likely to occur or that any portfolio is likely to achieve profits, losses or results similar to those shown. The scenarios do not represent all possible outcomes and the analysis does not take into account all aspects of risk. Scenario analysis assumes annual rebalancing. Rate shocks applied at the beginning of each rebalancing period. Total returns are estimated by re-pricing a key rate duration replicating portfolio of par coupon bonds every period. Option-adjusted spread is assumed constant over time.