David Peartree, The Daily Record Newswire
Investors are being warned to be wary of bonds because the effect of rising interest rates will be to crush bond prices. The warning is well founded — up to a point.
Rising rates will push bond prices down, but rising rates are not the only risk investors should be concerned about. And the remedy being suggested by some — getting out of bonds — may be akin to jumping out of the frying pan and into the fire.
We are in a period of historically low interest rates, even ultra-low rates. Over the course of a 30-year bull market in bonds, interest rates have trended down, boosting the total return of bonds. Remember that bonds have an inverse relationship between yield and price. Rising rates push prices down, and falling rates push prices up.
Since the financial crisis in 2008, the Federal Reserve has taken repeated steps to push interest rates even lower and keep them there. The average short-term government bond fund now yields a paltry 1.3 percent, according to Morningstar, which after inflation is a negative yield. Even the Vanguard Total Bond Market Index, a reasonably good proxy for the taxable bond market, only yields about 2.6 percent, just slightly better than the rate of inflation.
The potential impact of rising rates on bond prices is easy to grasp, even if the math behind it is not. A value known as “duration” is used to estimate the sensitivity of bond prices to interest rate changes.
Duration represents the percentage change in bond prices for each 1 percent rise (or fall) in interest rates. For example, a bond portfolio with a duration of 5 means that a 1 percent rise in rates can be expected to result in a 5 percent drop in portfolio value.
Even a 1 percent rise in rates could overwhelm the yield on many bond investments and produce a negative total return. Bond investors are not accustomed to this and the short-term impact would be a psychological blow, particularly if the increase were sharp and sudden.
Rising interest rates may not be the preferred environment for bonds, but this need not be a catastrophe and does have some benefits. Rising rates also means increasing levels of interest income, which, over time, can offset the decline in bond prices.
No one knows exactly how or when this will play out. In the meantime, bonds, and especially high quality bonds, continue to be an asset class with a low correlation to stock performance and, therefore, are an important stabilizer. Investors who think they can entirely replace bonds with dividend-paying stocks, for example, may be stepping into a level of risk they had not anticipated when markets decline.
Moreover, rising rates are not the only risk. Somewhat counter-intuitively, investors should also consider the risk that rates may not rise for quite some time. Years on end of zero interest rate policy by the Fed and ultra-low market rates amounts to financial repression, denying investors any meaningful returns and damaging the wealth of investors and savers.
Investors should not panic about a “bond bubble” and should not abandon ship by pulling out of bonds entirely. Few investors can do without bonds in their portfolio. Bonds offer two key attributes that make them ever valuable in a portfolio: 1) diversification via a low correlation to stocks and 2) income. Together these provide stability during turbulent markets.
For some perspective, consider the advice of Benjamin Graham, the man Warren Buffett acknowledges as his mentor. In his classic treatise on investing, “The Intelligent Investor,” Graham proposed as a “fundamental guiding rule” that investors should never have more than 75 percent of a portfolio in stocks and, for the inverse, not less than 25 percent in bonds.
Investing should be about stocks and bonds not stocks or bonds. These are complementary not competing asset classes. Investors should set their own strategic allocation, one that is maintained for the long-term and throughout market cycles. Of course, it should adjust over time as circumstances change, but if you don’t market time with stocks, why would you with bonds?
Here are some guidelines:
1. Manage interest rate risk by controlling “duration.” Investors can manage risk by keeping duration at a level where they are comfortable with the potential declind in price from rising rates.
2. Revisit diversification. However cliche it may be, being diversified remains solid advice. For bonds this can mean: a range of maturities, especially short term to intermediate; a range of issuer types or sectors; geographic range including global bonds; and a range of credit quality appropriately weighted to higher quality.
3. Vary the way you hold bonds. In a rising rate environment, individual bonds or target maturity bond funds that mimic a laddered bond portfolio have particular appeal. Unlike bond funds that never mature, these investments return the full principal value at maturity and can avoid realizing the market losses other bond funds might experience from rising rates. This needn’t be an either or proposition; individual bonds or target maturity funds can compliment traditional bond funds.
4. Set reasonable expectations for future bond returns. The current yield on bonds is a good approximation of their future returns. At today’s low rates, investors need to expect less and save more.
5. Keep costs under control. Einstein reportedly called compound interest the “eighth wonder of the world.” Its impact on long-term investment returns is stunning. But on the flip side, the impact of compounding expenses is insidious and eats into returns. In an era of lower returns, keep more by paying less.
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David Peartree, JD, CFP is the principal of Worth Considering, Inc. He can be contacted at david@worthconsidering.com.
