Are The Best Days Behind for Bonds?
Given the strong performance of bonds during the past year, you may have heard talk of a bond “bubble.” There are also fears that, because rising interest rates typically result in falling bond prices, bond mutual funds could get hammered if interest rates rise sharply.
It’s also been said that it’s not a question of “if;” but “when” rates must rise—an inevitability—and that the federal government will need to “print money” to repay rising federal deficits, which will lead to inflation. All of these factors can hurt bonds.
It may seem obvious that, if rates go up, bond values go down, ultimately hurting fixed income investors. However, investors should consider the nuances.
We won’t shortchange or discredit worries about rising federal deficits and increasing US Treasury issuance—we share those concerns. But we also remain committed to the belief that diversification matters, along with return of principal as well as income and lower volatility for a portion of your portfolio.
We’ll touch on what you can do to be well-positioned below. But first let’s hit a couple of key questions.
Are rising rates inevitable?
There’s no single interest rate just as there isn’t any single bond market. Most media discussion focuses on the federal funds rate—the interest rate banks charge each other for loans (usually overnight) and currently targeted between 0.0% to 0.25%. However, other interest rates may vary widely (and change less consistently) depending on maturity, type, sector, credit and other factors.
Just like stock markets, bond markets are forward-looking. Here’s an illustration of the yield curve today compared to average yields on Treasuries since January 1, 2000
Long-term rates anticipating future supply and inflation expectations
Source: Federal Reserve
Long-term interest rates have already begun to rise, while short-term rates have remained anchored by the Fed’s “crisis level” fed funds rate. The Fed influences long-term rates by its policies and actions, but has more direct control and impact on short-term rates.
Short-term interest rates, along with rates on short-term cash investments like savings accounts and CDs, will almost certainly rise as soon as the Fed adjusts current policy. But, as of now, we don’t foresee an uncontrolled steady rise in intermediate- and longer-term rates, such as we did during the late 1970s and early 1980s, when 10-year Treasury rates rose from under 6% to more than 15% over a 10-year period.
The period of “stagflation”—stagnant growth and high inflation—during the ’70s was driven by four primary factors:
- In late 1973, the US government decoupled the value of the dollar from the gold standard, increasing money supply and sending the price of gold soaring.
- Fuel costs—a much larger part of the average household budget than they are today—were also climbing dramatically.
- Wage pressures were increasing, caused in part by strong union controls over organized labor.
- A lack of commitment by the Fed to contain inflation and promote employment, above any other objectives.
Fortunately, none of these factors are in place today.
Should I sell my bonds before rates rise?
Fed interest rate futures markets currently anticipate a 75% probability that the Fed will bump up the short-term rate by its November meeting, but not before. Either way, timing the market is notoriously difficult, if not impossible, and we don’t recommend trying to do so.
Even if you could predict the move, an increase in the fed funds rate may not significantly impact rates on intermediate- or longer-term bonds. After a fed rate hike, short-term rates typically rise while intermediate- and long-term rates stay the same or rise less dramatically.
There are also opportunity costs. The risk in holding funds in short-term bonds or cash is no return at all. A move to cash or very short-term bonds risks the loss of potential higher interest payments.
If you’re most focused on generating income, and you hold individual bonds to maturity or bond funds over a longer-term horizon, interim changes in price may not be your primary concern. Bond returns come primarily from coupon payments, and bond fund income is distributed in the form of periodic dividends, and thus is not affected by change in price of the actual securities. This is especially true for individual bonds held to maturity.
To help gauge some of the relative risks for different bond types, see the chart below
Intermediate-term maturities: A better balance of risk and reward
Source: Bloomberg, Schwab Center for Financial Research, as of April 22, 2010.
Note: This chart assumes a “parallel” upward shift in yields from current rates by 1%, meaning that rates would rise 1% uniformly for Treasury bonds at each maturity. As mentioned previously in this article, there’s no single interest rate, and a rise in the short-term fed funds rate doesn’t always result in a corresponding rise in longer-term Treasury rates
Is there a bond “bubble?”
Since the beginning of 2009, more than $300 billion has flowed into domestic bond funds compared to a nearly $24 billion net outflow in domestic equities. Does this mean there’s a “bubble” in bonds?
A true bubble generally involves excess leverage or an irrational over-exuberance bordering on either euphoria (“This is too good to be true… give me more!”) or panic (“This is terrible… get me out!”). We simply don’t see these today in bonds.
In our opinion, there are several drivers for increased flows into bond funds: increased risk aversion in the wake of the stock market’s collapse, low yields on cash investments, and higher savings rates as investors realize that they must focus on return of capital for some of their money as well as return on investment.
One of the biggest drivers, we believe, is that many investors moving toward retirement have a lower risk tolerance than they may have realized and may have been underallocated to bonds compared to equities. Time will tell if this behavior continues, but what’s clear is that the US population isn’t getting any younger.
It’s hard to find bubble-like behavior here, especially in Treasuries. But higher-risk securities such as high-yield (“junk”) bonds or emerging-market bonds may be another matter. The unprecedented returns on these higher-risk sectors during the past year were driven by a bounce off the bottom of the credit crisis.
We suggest you consider taking some gains you may have off the table and don’t chase returns in higher-risk sectors too far. Rebalance to your targeted allocation—to higher-yielding, but also higher-risk, fixed income investments, just as you would with stocks.
How do I protect myself if rates do rise?
To help protect yourself, we suggest you adopt a broader view of the bond market as being more than just Treasuries, or a single interest rate or maturity, as do most professional bond managers.
With that in mind, consider these steps:
- Limit maturities for investments of money that you may need soon, by choosing short-term bonds or bond funds. For this part of a portfolio, lower yield is less important than the lower potential for a drop in the value should rates rise.
- Stick to intermediate-term bonds or bond funds for the core of your portfolio. The steadily leveling slope of the yield curve in the first chart illustrates that the benefit of rising rates decreases for each year of added maturity after a certain point on the curve. The “sweet spot” for all but the most income-oriented investor tends to be intermediate-term (five- to 10-year maturities).
- Include higher-yielding bonds such as corporate bonds (in moderation, and depending on your tolerance for credit risk) to temper the impact if rates rise. Use this simple rule of thumb: If coupons are higher, bond prices tend to fall less than bonds with lower coupons, like Treasuries. However, the risk if economic or credit conditions change is also higher.
- Consider non-US bonds to add diversification, if you’re concerned about US budget problems. This is the approach taken today by many professional investors, including those who’ve said that “better days may be behind for bonds,” and is why they’ve been adding to the international bond exposure in their own investment holdings. Do so in moderation: We suggest no more than 15% of your fixed income portfolio.
If all of these strategies sound complex, don’t fret. A well-managed intermediate-term bond or—for a more aggressive non-core bond-fund holding—a “multi-sector” bond fund (as defined by the Morningstar fund categories) can help you make many of these choices.
Today, professional credit selection matters, as do the details.
Do I change my long-term asset allocation or overall investment plan?
Bill Gross of PIMCO, who’s been widely quoted recently—by us, as well, in the title of this commentary—as saying that “the best days for bonds are behind us.” If you listen closer, he and other bond professionals are taking a broader view—of fixed income sectors, maturities and non-US investments.
He’s also been less-quoted as saying that investors’ target asset allocations shouldn’t change—they still depend on one’s time horizon and risk tolerance, and we agree.
Too much of anything is never a good thing, and that includes too much exposure to equities, especially if you’re concerned about volatility. This is true even if you believe (as we do) that equities tend to provide growth and higher returns over the longer term. So much media noise is built around extreme moves—“get out of this, put all of your money in that.”
We’re aware of the risks, and don’t believe bonds will outperform stocks for the next 10 years as they did during the past decade. But if you’re a more cautious investor, or have other investment priorities beyond maximum return without concern for relative risk, we still strongly recommend a well-diversified exposure to bonds.
Leave your response!