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Is The Great 30 Year Bond Bull Market Over – Part 2

BLOG, MARKETS & ECONOMICS, MOST RECENT  |  6 May 2013

What Effect Will It Have On Bonds and Bond Funds

When the first part of this article was written back in the middle of February, everyone was screaming that interest rates were going to continue higher and the bond bull market that has lasted for over 30 years was over. My, what a difference two months make. Since that article rates have dropped substantially. The rate on the 10 year treasury back then was about 2.05% and as of today is down to just around 1.7%.

That last sentence in that last article said the following:

Right now, it seems just about everyone hates bonds, and generally that is not the type of behavior that investors exhibit near the end of a bull market run. So although rates are due to rise, will it happen now, or could it still be a few years away?

It doesn’t look as if it is going to happen soon, especially when Ben Bernanke plans on continuing bond buying via his Quantitative Easing (QE) programs. Bernanke is more or less committed to buying $85 billion of bonds each month through the end of the year and possibly longer.

10 YR Treasury Yield
10 Year Treasury Yield since the beginning of 2013.

So, maybe the great bond bull market still has room to run. But there will be a day sometime in the future (not sure how near future) when interest rates do start to trend higher over the longer term. Thus, the average bond investor’s most common questions is:

What Effect Will Rising Rates Have on Bonds and/or Bond Funds?

Most people are aware that the investment returns on bonds do much better when interest rates are falling versus when rates are rising. This is because the price of bonds has an inverse relationship to interest rates. When interest rates are falling, bond prices rise, and conversely, when rates rise, bond prices fall. If you hold individual bonds until they mature, this is a non-event for you. The price of the bond you own may fluctuate while you hold it, but you will get the par or stated value of the bond back upon maturity. In the meantime you will collect interest payments twice a year as well.

However, if you sell your bond before maturity, you may end up with a price higher or lower than you paid for it originally, depending on whether rates are lower or higher then when you bought the bond. Most individual investors that buy bonds hold the bonds to maturity so, again, if you hold individual bonds until maturity, there are no gains or losses incurred at maturity, and you were able to collect interest payments the entire time you held the bond.

Most bond funds, however, own a portfolio of bonds and generally invest in bonds of a certain maturity date so that the fund has sort of a “target” average maturity in the portfolio. Maintaining this target average maturity requires the fund to buy and sell bonds continuously. If rates rise, the chances are the fund’s total return will go down (Total return includes both the interest payments received plus or minus the change in bond prices) as the value of the bonds the fund holds declines.

Bond funds with a longer average maturity date will generally be more sensitive to changes in interest rates. This sensitivity is known as duration. Duration is expressed as a number of years and is a complicated calculation involving the bond yield, coupon, maturity, present value and call features. The larger the duration number is, the more sensitive the bond or fund is to changes in interest rates. The rule of thumb for just how sensitive the bond or bond fund may be is that for every 1% change in interest rates, the value of your bond or fund will change by the duration.

For Example: If interest rates go up by 1% and the duration of your fund is 6.0 years, the fund value would decrease by about 6% in price. Of course you would still receive the interest payments, in the meantime, so your loss could be substantially less than 6%.

Generally, shorter term bond funds have shorter durations and thus would be less affected by rising rates. A short term bond fund with a duration of 2 would only see about a 2% decrease in price in the above example. The trade- off is that shorter term funds generally have lower yields and thus would not do as well as a longer duration fund when rates are falling. Duration works both ways, and in a falling rate environment longer duration funds have higher total returns.

Bond funds may lower durations by investing in shorter bonds that are lower in quality. These bonds will pay higher rates of interest to compensate for the additional credit risk, and since their duration is lower, they will not be as susceptible to losses if interest rates rise. However, they introduce another risk and that is credit risk, or the risk that you may not get all your money back. Because these types of bonds are issued by companies with lower credit ratings, they have increased chances of default compared to Government or AAA Corporate Bonds.

The benchmark for the overall bond market is known as the Barclay’s Aggregate Bond Index. It is comprised of a combination of government, mortgage backed, and corporate bonds with an average maturity of 10 years. Since the 1980 peak in interest rates this index has had only 1 year in which it lost money. That was in 1994 when the total return (including interest received) was -2.92%.

1994 was the year that Fortune Magazine dubbed the Great Bond Market Massacre. With an improving economy, Chairman Alan Greenspan and the Federal Reserve hiked short term interest rates 6 times during the year for a total increase of 2.5%. To give you a comparison, here are the total returns for certain areas of the bond market in 1994 after this large rise in interest rates:

Bond Type 1994 Total Return
Barclay’s Aggregate Bond Index -2.92%
Long Term Government Bonds (20 yrs) -7.77%
Intermediate Term Government Bonds (7-10 yrs) -5.14%
Long Term Corporate Bonds (20 yrs) -5.76%
Barclays High Yield Bond Index (Junk Bonds) -1.0%

Another time frame to look at for bonds performance in a prolonged rising rate environment is the period during the Eisenhower administration of 1955-1959. The 10 Year treasury yield was 2.61 at the beginning of 1955 and steadily rose to 4.72% by the end of 1959. Here is a look at how certain areas of the bond market performed (total return) in this period:

YEAR

LONG – TERM

GOVERNMENT BONDS

LONG – TERM

CORPORATE BONDS

INTERMEDIATE TERM TREASURIES

1955

-1.3%

0.5%

-0.7%

1956

-5.6%

-6.8%

-0.4%

1957

7.5%

8.7%

7.8%

1958

-6.1%

-2.2%

-1.3%

1959

-2.3%

-1.0%

-0.4%

1955-1959 TOTALS

-8.11%

-1.42%

4.81%

                                                              Source: Ibbotson : Stocks, Bonds, Bills & Inflation 1926-2012

You can see that in periods of rising rates, long term bonds really take it on the chin. However, if you keep maturities short, modest returns can still be obtained even when there are several years of rising rates. Thus, one way to ride out a period of rising rates is to keep maturities on your bond funds short.

The above results just show the performance of the bond indexes during these rising rate timeframes. Some bond fund managers can be very agile in shortening the maturities of the bonds they own as well as exploring other areas of the bond market that may not be as sensitive to interest rates. They may even “short” interest rates and profit as rates rise. It appears that active management of bond funds can sometimes add value in a rising rate climate versus a bond fund that just tracks an index.

True, most bond indexes and funds that try to track those indices will not perform all that well if rates rise for a prolonged period of time. But, there are a number of highly skilled bond fund managers that have the ability to successfully navigate negative market environments and have an excellent chance of producing acceptable returns even with higher interest rates.

Diversifying the bond portfolio into several areas of the bond market besides just U.S. Government securities is also important. One major concern is the inability of Congress to construct a sensible approach to reducing our budget deficits which has already caused one downgrade of U.S. Treasuries. The United States is still the gold standard among nations, but continued failure could change that standing.

Although all areas of the bond market are affected by interest rate changes, the degree of change will differ among different areas. Spreading the bond portfolio among many different areas will help weather higher interest rates. These areas may include corporate bonds, mortgage backed bonds, foreign bonds, emerging markets bonds, preferred stock, floating rate bonds, municipal bonds, etc.

There are also funds available that allow you to profit from rising longer term interest rates. These funds go up in value as rates rise, but lose value if rates decline. If one has longer maturity bonds or bond funds in their portfolio that they do not wish to sell, they can hedge their portfolio using these types of funds.

Investors that include bonds in their portfolios because they are a great diversifier need not fear rising interest rates. Utilizing bond ladders and/or good quality bond fund managers, one can navigate a higher rate market climate and still generate income and reduced volatility through portfolio diversification. However, it will be much more challenging for bond investors than it has been in the past several years.

In the next installment of this series we will get into ways to obtain higher yields despite the ultra-low interest rates. However, since there is no “free lunch” in investing we will also discuss the trade-offs that an investor makes by utilizing these higher yielding securities.