Interest Rates are Up, Are Bonds in Trouble?
Why Bond Investors Shouldn’t Panic
by Jon Aldrich
Two events occurred in the last quarter of 2016 that many thought may never happen. The first was the Chicago Cubs winning the World Series and the second was, after many years of ultra-low rates, interest rates finally started rising.
Since Donald Trump was elected, back in early November, interest rates both short and longer term have spiked upward. Why? Well, the stock and bond markets are expecting Mr. Trump’s economic policies to be stimulative to business and the economy due to reduced government regulation, lower corporate tax rates and expected infrastructure spending. A more vibrant economy leads to higher interest rates as the Federal Reserve will not need to keep rates ultra-low to try to stimulate economic growth and its focus will shift to making sure inflation does not get out of hand and raising short-term interest rates to more normal levels. This in turn will eventually lead to higher rates on money market funds and Certificates of Deposit, which will be a welcome relief for those looking for safe yields on their savings. It will, though, also lead to higher rates on things such as mortgages and car loans.
The 10-year Treasury Bond which is the benchmark for intermediate term interest rates rose from 1.57% on Sep 1st to 2.57% on December 27th. (That is a 63% rise in basically 4 months). This was the biggest rise since the Taper Tantrum spike in interest rates in 2013 when the 10 year treasury spiked from 1.66% in May of that year to 3.0% at the end of the year.
The higher interest rates have affected bond and bond fund prices as the prices of bonds and bond funds move in the opposite direction of interest rates. (When interest rates drop, the prices of bonds rise, and when interest rates rise, bond prices fall). Those of you that own bonds in your portfolios have seen the value of your bonds and funds drop in value the last 3 months of the year because of the rise in rates. When interest rates rise sharply like they have recently, bonds and bond funds lose value in the short term, but are poised to perform better in the longer term as bond fund managers can reinvest into bonds with higher interest rates which will provide higher yields in the future.
Also, to keep this simple, it is worth noting that generally bonds & bond funds with longer maturities are going to be much more affected by changes in interest rates than those bonds or funds with shorter maturities. (I am not going to get into what bond duration is and the difference between bond duration and maturity here, as this article is not meant as a sleeping aid, but you can go here to get a good description of this concept and what it means to bond investors) The following chart shows the total performance of 3 Vanguard Bond funds that hold bonds of different average maturities:
BSV (Red line) = Vanguard Short Term Bond Index (average maturity 2.9 years)
BIV (Blue line) = Vanguard Intermediate Term Bond (average maturity 7.3 years)
BLV (Orange line) = Vanguard Long Term Bond (average maturity 24 years)
So, when we had the 1% spike mentioned above in interest rates, you can see that long-term bonds dropped by over 10%, while the short-term bonds only dropped a little over 1%. (The intermediate term bonds were off close to 5%) Of course when interest rates drop the results would flip, and the long-term bonds would do much better than the short-term bonds. We have generally stuck to short and intermediate term bonds in client portfolios the last couple of years in anticipation of interest rates moving higher.
Vanguard did some research back in 2013, the last time everyone was concerned about rising interest rates and found that after the initial spike in interest rates and the subsequent drop in the value of bond funds, that after a couple of years these losses are more than made up because of reinvesting in higher yielding bonds. Vanguard’s research also modeled a much greater spike in interest rates than what we have seen or expect to see. We also wrote about this topic back in 2013 when interest rates last jumped.
Some people that remember the 1970’s tell horror stories of the large losses in bond funds because of the rise in interest rates. But the environment at that time was much different than where we are now as it was a time of high and rising rates and high inflation which is a far cry from the current scenario of low and rising rates and very modest inflation. Central banks are also much more proactive in fighting inflation than they were back in the 1970’s before Paul Volcker led the Federal reserve in the charge to keep inflation in check.
You also must remember as to why you have bonds in the portfolio in the first place. They serve as a diversifier and buffer for equity holdings and to provide income. As rates, do rise, it will allow bond holders to start generating more income again, which we have been hoping would occur for a long time now. Anyone who has been trying to get some income from safe income sources such as Certificates of Deposit, money market accounts, or high quality bonds can attest to this.
It is also worth noting that a bad year for stocks is much worse than a bad year for bonds. As you can see in the table below, that although annualized returns for bonds are less than stocks, the number of times that bonds show a loss as well as the amount of the losses is far less than what it is for stocks. The chart below uses data going back to 1926, so it includes plenty of periods of rising interest rates.
The market is expecting Trump’s policies to be inflationary and that is why interest rates have risen quite rapidly of late, but once he takes office it remains to be seen how many of his proposals will actually be enacted into law. If some of the anticipated proposals don’t materialize, you could see interest rates fall back quickly as the reality that things may not be as pro-growth as originally believed. If that happens, prices of bonds will rally and you may see stocks drop. This gets back to the reason you have bonds in the first place. In the short term, bonds may struggle if rates continue to rise, but in the longer term the benefits of higher interest rates and the income generated from bonds will reward patient, long-term investors.