With interest rates at historic lows, there is little doubt they will rise at some point, but when will this finally occur? What will be the catalysts that finally precipitate the rate increases that everyone has been waiting for? No one knows for sure. However, the most important question to our clients is whether anything can be done in bond portfolios to prepare for future increases in interest rates, whenever they may finally occur. In this discussion we will talk about why, even in this environment of seemingly certain rate increases, we believe maintaining an allocation to bonds of intermediate maturity remains prudent.
Why do we own bonds in the first place?
Since talking about bonds these days tends to generate a fair amount of anxiety, let’s begin by articulating why we own fixed income assets in the first place.
Income. Although current yields are at all-time lows, the income that bonds provide is still higher than cash. The yield on the US aggregate bond index is currently 1.7%, which is 1.5% more than the average money market fund or interest-bearing checking account.
Preservation of capital. If one thinks of stocks as an engine of portfolio growth, bonds might be considered the brakes that help us from swerving off the road in difficult conditions. In times of poor equity market performance, bonds tend to generate positive total returns, and in doing so buffer the losses of equity investments. The chart at left illustrates this point by showing bond returns in the worst equity market performance periods since 1976. An allocation to investment grade bonds preserves capital in difficult stock market environments and provides a resource for rebalancing equities. Thus, bonds are a powerful diversifier and a key ingredient to strategically helping our clients reach their goals.
Should we try to time the bond market?
Some investors are tempted to sell bonds in favor of cash in order to protect themselves from the adverse effects of interest rate movements. If one considers moving to cash though, they should first consider the fact that even professional investors and economists do not accurately predict the timing of interest rate movements. To demonstrate this, we can look at something called the forward curve, which, simply put, represents the market’s future expectations for interest rates. The forward predictions are nearly always off the mark, which creates the blurriness in the graph at right. Given the high tendency for error, we do not believe that trying to time the market makes sense.
What is the risk, really?
The preceding illustration serves to prove the difficulties of timing the bond market. However, many investors are less concerned with getting the timing perfectly right than with simply reducing risk. To truly put this in the proper context, let’s look at the greatest risk that bondholders face.
Assuming good credit quality, the greatest risk an investor in bonds faces is the risk of rates rising. As rates rise, the price of an existing bond (or bond portfolio) will fall. This concept is embodied by a financial concept called duration. A bond’s duration is most affected by its time left until maturity and the amount of interest that it pays each year. Knowing a bond’s duration provides the ability to mathematically determine how much that bond will be affected by rising interest rates. For example, if a bond has a duration of 5 and interest rates were to increase by 2%, then the bond’s value would be expected to fall by 10%.
Now let’s take this basic concept and evaluate three potential cases for a hypothetical $100,000 bond portfolio over the next ten years. The duration of the Barclays US Aggregate Bond Index is currently around 4.8, with a yield of 1.7%. We will assume this as a proxy for our hypothetical bond portfolio.
Scenario 1: We maintain our strategic bond allocation, and there is a 5% increase in interest rates tomorrow. This is a very extreme example, as the highest increase in any 12 month period since 1976 has been 4.1%. However, this is the sort of scenario that most worries investors, so it is worth investigating. If interest rates were to increase 5% in one year, our hypothetical bond portfolio would lose 20% or $20,000. While this is a significant loss, remember that we now have the opportunity to reinvest at 6.7% going forward, so we would have fully recouped our loss in 4 – 5 years. By year 10, we would have a net gain of almost $44,000.
Scenario 2: We maintain our strategic bond allocation, and rates stay at current levels for the next ten years. Admittedly, this scenario seems unlikely, but it is not unprecedented. For context, Japan’s rates have been below 2% for over 15 years now. In this scenario, our gain over ten years would be $18,500, which is less than half of what was earned in the first scenario. So, in spite of the 20% initial investment loss in Scenario 1, higher interest rates actually benefit for bondholders when measured over a long period of time.
Scenario 3: Hold cash instead of bonds, but rates stay at current levels for the next ten years. The logic here is that you hold cash to avoid any principal value decline, wait until rates rise, and then buy bonds at higher yields. You experience no loss and achieve higher yields. Voila, you have your cake and eat it too. With cash yielding next to nothing though, problems quickly occur if higher rates do not materialize in a short period of time and you continue holding cash. So this case essentially illustrates what happens if an investor sits in cash indefinitely. This scenario translates into only $2,500 growth over 10 years assuming a .5% yield on cash (which is a generous assumption in today’s yield environment).
The clear conclusion is that maintaining the bond portfolio makes the most sense unless one can predict the timing of interest rate movements. Even if rates were to increase significantly, the initial price decline of the bonds is eventually offset by the higher yields the portfolio will generate going forward. An investor with a long time horizon should actually desire higher rates.
All risks are not created equal. Many who are fearful of bond markets these days are placing fixed income risks on an equal footing with the terrible 20% – 50% declines that sometimes occur in equities. Barring massive defaults though, this is simply not the reality. Most important, in contrast to equity markets, the timing of the regained value in bonds is mathematically predictable.
The historical reality
Since the preceding examples are only hypothetical, let’s look at what actually happened to the US Aggregate Bond Index during periods of rising rates in the last 40 years. The table at right illustrates that only one of those periods resulted in a negative annualized return (1993-1994).
For additional context, let’s look at what happened in historical rolling 3-year time periods. A 3-year time period is meaningful because this is the minimum time horizon for which we would ever recommend owning intermediate or long-term bonds. In other words, if there are known specific cash needs that will occur within three years, we would recommend holding cash or very short-term bonds rather than longer term bonds. With this perspective, the rolling 3-year return of the US Aggregate Index has dipped into negative territory only twice (1979 and 1981) since the index’s inception; and this occurred during one of the most severe rate increases in US history.
Historical data verifies the conclusions we formed above in our hypothetical scenarios. Despite the meaningful price drops that occur in bonds at the time of rate increases, overall bond market returns have not been as bad as one might expect due to the fact that bondholders quickly benefit from the higher interest rates. (The illustration at left provides a picture of this during the difficult investment period from 1975- 1983.)
Paracle’s fixed income portfolio structure reduces risk
One of the key tenets of Paracle’s fixed income philosophy is holding a portfolio with an intermediate-term duration of 3 – 7 years. Holding an intermediate duration rather than a longer-term duration helps to offset the risk of rising rates, while still maintaining a reasonable level of yield. (The graph at right illustrates this concept.) Additionally, our bond managers have the flexibility to reduce their portfolio’s duration to the shorter end of the intermediate range. Maintaining a strategic intermediate duration and allowing our managers flexibility to determine their position within the intermediate spectrum helps to reduce losses in the value of our clients’ bond portfolios in the event of an increase in rates.
But I am still nervous
We recognize that these seem like unprecedented economic times and we understand that many investors will remain nervous about owning bonds. Although our recommendation is to maintain a strategic allocation to intermediate bonds, those who want to take further steps to mitigate risk might consider the following options:
Hold more short-term bonds. We maintain a roster of great short-term bond strategies. These strategies are typically utilized to provide resources for upcoming client cash needs. However, layering these shorter-term strategies in with intermediate strategies effectively serves to further reduce the overall bond portfolio’s duration. It is important to note though that doing so will also reduce the portfolio’s yield. (As usual, taking less risk can be expected to result in lower return.)
Increase the allocation to non-traditional investments. Since non-traditional investments were the subject of our 4th Quarter 2012 newsletter, we will not go into great detail here. Suffice it to say that many who are nervous regarding interest rate increases here in the US are also concerned with other things, including loss in value of the US dollar, inflation, etc. These concerns are specifically addressed in the structure of our non-traditional portfolio, and the non-traditional portfolio can be expected to help offset these risks. It is important to remember though that non-traditional investments entail risks of their own. (They are less risky than equities, but more risky than bonds.)
Pay down a mortgage early. If you think about it, mortgages are bonds in reverse. You are paying interest rather than being paid interest. As the saying goes, a penny saved is a penny earned. With mortgage rates at all-time lows, paying down the mortgage may not seem like a no-brainer. And truth be told, paying down the mortgage is not likely going to achieve the highest possible long-term return. Remember though, here we are talking about ways to reduce risk rather than to maximize return.
We hope that you find these perspectives helpful and are eager to discuss any aspects that you would like to cover in greater detail.