Interest rate risk has been THE big worry for bond investors for a number of years now. It seems that everyone has been predicting a rise in interest rates, but it just hasn’t happened quite yet.
This has caused many investors to shift their bond allocation in anticipation of a rate increase and price losses in bonds. The problem when making wholesale portfolio changes based on these fears is the timing, as always.
When rates do finally rise bond prices will fall as they’re inversely related to interest rates, but the losses need to be put into perspective. Last year Vanguard performed a study on the effects of an unexpected 3% rise in rates on the Barclays Aggregate Bond Index over five years:
In this example the initial rise would lead to a steep loss in the near-term (almost 13% on the first year). But as newer bond holdings would get added to the index at the now higher interest rates as older bonds matured the performance would play catch-up. In this scenario the bond market ends up being positive within 4 years.
Also, it’s worth noting that even under this more than doubling of rates from their current levels, these losses are a fraction of the 50% declines that investors have experienced in stocks over the past two decades. A terrible year in high-quality bonds is a bad week in the stock market.
In fact, if you go back to the last period of a sustained rising rate environment from the early 1950s to the early 1980s the annual losses in 10 year treasuries were never really that significant:
Annual losses in the 1950s: -0.30%, -1.34%, -2.26%, -2.10%, -2.65%
Annual losses in the 1960s: -1.58%, -5.01%
Annual losses in the 1970s: -0.78%
The reason there were never any huge losses is because rates slowly crept up over time. In 1950 the 10 year yield was 2.3% while it finished the decade at 4.7%. In the 1960s rates went from 4.7% to 7.8% and by 1980 rates were at 10.8% before finally topping out at 15.3% in 1981.
This slow churn higher until the very end meant that there were never any shocks that led to large drawdowns in bonds.
Yet even with a quick spike higher in yields, as the Vanguard study showed, bond investors can recover from interest rate risk over time. There are a number of other risks to consider when investing in bonds that are potentially more harmful than rising rates.
Inflation Risk: Bond returns weren’t terrible on a nominal basis in the previous rising rate environment referenced above. It was the after-inflation real returns that hurt investors:
In fact, from 1950-1981 inflation led to nearly 40% losses in real terms for 10 year treasuries. But it was more of a death by a thousand cuts than a crash like we see in the stock market.
Generally, the longer the holding period for bonds the higher the inflation risk.
Credit Risk: Investors that are chasing yield in lower qualiity bonds are doing so by increasing their credit or default risk. Higher yielding fixed income offers those higher yields because the issuers of the bonds have a better chance of defaulting on their debt.
Credit risk doesn’t only concern defaults either. A downgrade in the credit rating of a bond by the credit agencies can affect bond performance as well if institutional investors are forced to sell because of restrictions on the credit quality of the bonds they’re able to hold.
Liquidity Risk: Bonds aren’t as liquid as stocks for trading purposes. This can lead to short-term selling pressure in bond ETFs and mutual funds. There can be a mismatch between the liquidity of the individual holdings and the overall funds.
When everyone heads for the exits all at once it could accelerate the losses in these funds beyond their net asset value. The prescription for this risk is to never be in the position to have to liquidate an entire position just because it’s getting killed in the short-term.
Duration Risk: If interest rates do ever decide to rise, duration will be the most important statistic for bond investors to pay attention to. In the Vanguard study the 5.5 year duration of the fund meant that for a 1% increase in yields you would expect the price to fall by roughly 5.5%. Longer maturity bonds have higher durations along with higher yields.
The higher the duration of a bond or fund the higher the potential for volatility in both directions when rates move.
It’s worth noting that many of these risks are related. You can’t simply hedge one of these risks without affecting the others. There’s no such thing as ‘all else equal’ in the financial markets as nothing occurs in a vacuum.
We have to consider why interest rates could rise and how each risk factor would be affected. When it happens it will likely be for a number of different reasons including a combination of higher economic growth, higher inflation, lower risk aversion or a pullback in bond purchases by the Fed.
The only thing we can say with any certainty is that bond returns will be much lower going forward than they’ve been since the early 1980s. They have to be because interest rates can only fall so much further and lower yields means less interest income.
Therefore the biggest risk bond investors face is misaligning expectations with this reality.
Photo: Chris Butterworth
Recommended for You
Why did Hillary Clinton reward Debbie Wasserman Schultz after WikiLeaks published emails that exposed how the supposedly neutral DNC Chair helped undermine Bernie Sanders and abused her office? Clinton elevated the disgraced operative to Honorary Co-Chair of her campaign, further enraging Bernie’s…The Fiscal Times
Cramer said the company is just doing "some self help," but other analysts fear a decline for the restaurant industry.The Street
Apple wants to be more than just a company that makes iPhones and is growing revenue from services, up 19 percent in its fiscal third quarter.CNBC
NEW YORK (AP) — Four days after the ouster of Roger Ailes as Fox News chief, two more executives at the network have been axed.Associated Press
SPARKS, Nev. (AP) — It's Tesla Motors' biggest bet yet: a massive, $5 billion factory in the Nevada desert that could nearly double the world's production of lithium-ion batteries.Associated Press
Are you bullish on General Electric (GE), the way we at Barron's have been? You might want to consider this as a warning from JPMorgan's C. Stephen Tusa and team: As usual the General Electric quarter contained a myriad of moving parts, but as the hysteria around transformation fades, and the focus…Barrons
July 26 -- Yale University Economics Professor Robert Shiller discusses results of the May S&P CoreLogic Case-Shiller Index of home prices, his outlook for the Federal Reserve's rate hike path and the "unusual world" of interest rates. He speaks on "Bloomberg Markets."Bloomberg Video
- Advance AmericaSponsored
We keep the tough going with 2,300 convenient locations, 6,500 helpful employees & a 97% customer satisfaction rating. Talk about strength in numbers.
Chart-minded trader Todd Gordon is making a bold play on the tech giant ahead of earnings.CNBC.com
The failed coup in Turkey on July 15-16 has done exactly what many experts predicted: It’s given Turkey’s President Recep Tayyip Erdogan a green light to implement the next stage of his plan to turn the country into an Islamic state. Turkey has been a particularly important NATO ally of the United…The Fiscal Times
Jim Cramer rattles off his take on caller favorite stocks, including this stock that made him feel emboldened after Caterpillar earnings.CNBC
SAN FRANCISCO (AP) — A nearly $15 billion settlement over Volkswagen's emissions cheating scandal cleared a key hurdle Tuesday, with a federal judge giving preliminary approval to the deal that includes an option for owners to have the carmaker buy back their vehicles.Associated Press
Refining maintenance season is a few weeks away, a period of time that could be hugely negative for oil pricesOilprice.com
Shares of Celgene (CELG) are sinking today after the biotech company reported disappointing results from a trial of Revlimid as a treatment for lymphoma. RBC's Michael Yee and Judy Liu explain why the selloff could be a buying opportunity: Celgene just announced the Revlimid Phase III REMARC data –…Barrons
The The Woodlands, Texas-based company said it had net income of 36 cents per share. Earnings, adjusted for restructuring costs and non-recurring costs, were 53 cents per share. The results beat Wall Street ...Associated Press
Before you can reach your lump sum goal, estimate the income required to support the retirement you want.Kiplinger.com
Japan's Line Corp (3938.T) (LN.N) on Wednesday said soaring advertising revenue helped it swing into profit in the first half of the year, in the messaging app maker's first public earnings report since its billion-dollar stock market listing. Line enjoyed a stellar debut on both the Tokyo and New…Reuters
July 25 -- NYU Stern School of Business Professor Scott Galloway examines Verizon's $4.83 billion purchase of Yahoo's web business and the tenure of Yahoo Chief Executive Officer Marissa Mayer. He speaks with Bloomberg's Alix Steel on "Bloomberg ‹GO›."Bloomberg Video
SEOUL, South Korea (AP) — LG Display Co., a supplier of Apple's iPhone screens, said Wednesday that it will invest 1.99 trillion won ($1.75 billion) to produce flexible displays for smartphones, in a sign that more high-end smartphone makers may adopt flexible screens in the near future.Associated Press
Deutsche Bank AG said second-quarter revenue dropped at its prime finance unit, extending a slump beyond businesses that Germany’s largest lender is seeking to exit as client concerns added to volatile ...Bloomberg
Gold steadied near $1,320 an ounce on Wednesday as traders awaited the outcome of a two-day Federal Reserve policy meeting later, which will be closely watched for any clues on the scale and pace of interest rate hikes this year. Spot gold was $1,319.56 an ounce at 1200 GMT, little changed from…Reuters30 mins ago