With the 10-year Treasury yield hovering around 3% and last spring's rout still fresh in investors' minds, conventional wisdom seems to hold that higher rates will decimate bond prices. But does history bear that out?
In this article, we review historical interest rate and performance data to evaluate the impact rising rates have had on the bond market in years past under a variety of conditions. We then discuss the strategies we believe will be most effective in protecting capital if and when interest rates move higher.
To conduct our analysis, we compile yield and return data for the Ibbotson Associates SBBI Intermediate-Term Government Bond Index covering every month from January 1946 through September 2013. Using that data, we pinpoint consecutive multimonth periods in which yields rose more than 10 basis points and then calculate the index's total return during those periods.
We choose the Ibbotson index for a few reasons. First, we are trying to isolate the impact of rate changes spurred by rising real yields and evolving inflationary expectations, not widening credit spreads, making a government bond benchmark most suitable. Second, the index targets a five-year maturity, which makes it a rough proxy for the interest-rate sensitivity of "core" portfolios. Third, the Ibbotson index extends back nearly seven decades, a track record that's particularly useful given the different interest rate regimes seen in the post-World War II period.
We find there were 64 multimonth periods in which the Ibbotson index's yield climbed more than 10 basis points. The magnitude of rate increases range from a minimum of just 16 basis points to a maximum of more than 468 basis points, with a median increase of 94 basis points. Similarly, the rising-rate periods vary significantly in terms of length, ranging from as little as two months to as many as 21 months, with a median length of about five months.
Despite popular belief to the contrary, rising rates are not an albatross for the Ibbotson index's performance, at least when viewed in a certain light. Indeed, when we sort by return, we find the index ekes out a nominal return of 22 basis points during these periods, which is hardly the bloodbath some might have expected.
However, some important caveats apply. For one, there is a pretty wide disparity of returns, ranging from a 5.53% cumulative nominal loss (September 1993 to December 1994 when rates rose 297 basis points) to a 5.87% cumulative nominal gain (November 1976 to June 1978, when rates rose 250 basis points). In addition, the median after-inflation return is nothing to write home about--a 1.49% cumulative loss. In other words, rising-rate periods aren't interchangeable--we find a bond investor's experience could differ significantly based on factors specific to the rising-period concerned, such as the level of prevailing yields and inflation.
Given that the headline figures don't necessarily tell the whole story, we drill-down further to better identify telling similarities and differences between various rising-rate periods and subsequent bond returns. We assign each of the 64 rising-rate periods to one of four groups based on the level of yields that were prevailing at the time the rate increase began: prevailing yields below 4%, between 4% and 8%, between 8% and 12%, and 12% and greater.
Then, within each yield group, we break down the rising-rate periods further based on the inflation rate experienced in the 12-months immediately preceding the rising-rate periods concerned. We use four inflation groupings for this purpose: 12-month inflation less than 2%, between 2% and 4%, between 4% and 8%, and 8% or more. Thus, there are 16 distinct groups (four yield groupings times four inflation groupings) to which a given rising-rate period could have been assigned.
Our first pass through the data suggests that, regardless of prevailing yield level or inflation rate, nominal returns remained roughly flat during periods of rising rates (Exhibit 1). For example, in the two instances in which prevailing yields are below 4% and inflation is 8% or above, the median cumulative nominal return is 67 basis points. In the three instances in which the prevailing yield is between 8% and 12% and inflation is 8% or greater, the median cumulative nominal return was a 49-point loss. A change of sign to be sure but hardly a significant move.
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However, the same cannot be said of real returns. Indeed, the lower prevailing yields are at the beginning of a rising-rate period and the higher inflation is running in the 12 months preceding that rising-rate period, the worse real returns tend to be. For example, when prevailing yields are below 4%, rising rates almost invariably lead to negative real returns, which grow dramatically worse during periods of higher inflation. By contrast, when yields are 4% and above, real losses tend to be less severe, regardless of the inflationary environment.
This makes intuitive sense. At low yields, the index has less income to offset the real price decline that results from rising rates, and high inflation only compounds the problem. At higher prevailing yields, however, the index has a fatter cushion to sustain rate-associated losses and withstand the bite even very high inflation can take out of its returns.
Of course, not all rate increases are created equal, as a 50-basis-point rate move looms larger when prevailing yields are sitting at, say, 3% than when they're hovering around 10%.
With that in mind, we perform a variation of the previous analysis, but this time considering the magnitude of the rate change relative to the prevailing yields at the beginning of each rising-rate period. (In other words, we divide the rate increase by the index's yield at the beginning of each rising rate period.)
What we find is pretty stark (Exhibit 2). When the rate move accounts for less than 10% of the index's prevailing yield, the index tends to hold steady, even after accounting for inflation. However, when it accounts for 20% or more, real returns fall off, sometimes dramatically. And the higher inflation runs, the more damage the rate increases tend to inflict on the index's real returns.
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What Does This Tell Us About Today?
The current bond market environment is characterized by both low yields and low inflation. On Sept. 30, 2013, the Ibbotson index was yielding 1.06%, which was 396 basis points below its historical median. Meanwhile, the 12-month annual inflation clocked in at 1.5% as of August 2013, suggesting our economy has experienced inflation below the historical average over the past year.
This is good and bad news. On one hand, real returns tend to be poorest when recent inflation is high, yet inflation has been remarkably subdued in recent years. Thus, bond investors could draw some sustenance from the low-inflation climate in which they find themselves, which makes it less likely that returns will be horrible, at least in the event of a near-term rate rise.
On the other hand, rates likely wouldn't have to jump by much before the magnitude of the move represented a large percentage of the current 1.06% yield. If history is any precedent, that could prove fairly damaging to bond returns, at least in the short run. Consider this past spring, when the Ibbotson index dropped 234 basis points between May and the end of June due to a 53-basis-point move in rates. Furthermore, should inflation surprise on the upside, any rate spike would likely be all the more painful.
Managing Through Rising Rates
The question then becomes how to manage the bond portion of a portfolio in the event rates do in fact rise. For many, the obvious course of action is to sell bonds altogether and buy back in when rates are higher, thereby avoiding the losses and later benefiting from higher yields.
While tempting, we think this could prove a mistake. For one, rates may not rise for quite some time. As a result, investors who sit in cash could ensure they earn less than inflation while they wait. Those who turn to the equity market, meanwhile, may find they experience more volatility in the interim than is appropriate for their risk tolerance. Second, rate moves are extremely difficult to predict. Regardless of where investors put their bond money while waiting for rates to rise, they could find getting back in the market could prove more difficult than many expect. Indeed, they could return to the market in time for yet another move higher in interest rates.
Rather than attempting to time the market, we think it's worth remembering the role bonds play in portfolio construction. With a fair amount of predictability to their income stream, they are prone to significantly less volatility than other asset classes, the equity market in particular. Since a move higher in rates doesn't compromise this advantage, investors can still count on them to act as portfolio stabilizers, even in an environment characterized by rising rates.
That doesn't mean investors should bury their portfolios in Treasuries and resign themselves to losses. While bonds issued by corporates aren't immune to rising rates, their larger coupons mean they often suffer less when rates are on the rise. In fact, with the Barclays U.S. Corporate Investment-Grade Bond Index yielding 3.3% relative to the 1.06% for the Ibbotson index at the end of September, our historical analysis suggests that, all things held equal, investment-grade corporate bonds could withstand an interest-rate increase of a much higher magnitude before experiencing significant losses.
Given the damage high inflation can cause when rates are on the rise, investors may also want to consider an allocation to bonds that offer an inflation hedge. Enter TIPS. Although vulnerable to a rise in real rates, particularly in light of their low current yields, these bonds will not experience the same real losses as nominal bonds because of the inflation adjustment baked into their principal. And while they are hardly screaming buys, the sell-off they experienced earlier in 2013 means they are cheaper now than they've been for two years.
Hang In There
The future for bonds likely won't mimic the past. The risk of rising rates is real and could be costly if the magnitude of the move proves large. And even if rates stay steady, bonds no longer benefit from the tailwind of falling yields, which spurred impressive gains since the 1980s.
Nevertheless, we don't believe investors should jettison them from portfolios altogether. Bonds still retain their utility as portfolio stabilizers, and prudent allocations to credit-sensitive and inflation-hedging sectors could help minimize damage caused by a rising-rate environment.
The opinions expressed herein are those of Morningstar Investment Services, are as of the date written and are subject to change without notice, do not constitute investment advice and are provided solely for informational purposes and therefore are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar Investment Services shall not be responsible for any trading decisions, damages, or other loses resulting from, or related to, the information data, analyses or opinions or their use.
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