This article is part of a regular series of thought leadership pieces from some of the more influential ETF strategists in the money management industry. Today’s article features Dan Egan, director of behavioral finance and investing at the New York-based automated investing service Betterment.
Contrary to conventional wisdom, rising interest rates can be good for a bond portfolio.
Investors might think otherwise because of the mechanics of very basic bond math (when rates go up, yields go up and prices go down). But that’s not the whole story: A diversified bond basket can actually benefit when rates rise.
As an example, the light blue line on this graph is the return of VBMFX, a very close proxy of the Vanguard Total Bond Market fund (BND | A-94) over the subsequent two years from the date on the x-axis.
This allows us to map the performance of the bond fund to the interest rates represented by the dark blue line. The dark blue line is the risk-free rate, or the “effective federal funds rate,” which is what banks charge each other based on their deposits at the Federal Reserve, and the primary benchmark for interest rates. The gray periods highlight when interest rates were rising.
Over the past 25 years, the two-year rolling return of BND—a bond fund diversified by maturity, credit quality and geography—actually increases, not decreases, after interest rates rise.
Beyond Simple Bond Math
Why? It’s because of how the bond market really works, beyond the simplistic bond math in investing 101. What is that?
Bond prices today have as much to do with expectations for the future as the actual level of interest rates today. So a rate rise can be “priced in” for a long time before it happens.
The element of time, or what might happen over the duration of the bond fund, and what other investors in the market expect over the long term.
Yes, very-short-term rates reflect the policy set by the Federal Reserve. However, for most bonds, current yields and prices also reflect market participants’ beliefs about future changes to that policy. Bond yields can jump on the expectation of a rate rise, even if it doesn’t happen for a while.
As I have written about before, market expectations are already reflected in prices. The fact that interest rates will rise at some point isn't exactly secret knowledge, so how are active managers going to beat the market?
Market Moves Before The Fed
Critically, the market usually moves slowly and before the Fed announces changes. The Fed is getting better and better at transparently communicating its likely future decisions, specifically to keep the bond market operating smoothly. As a result, rate moves are often smoothly reflected in prices before they actually happen. That makes it tougher for an active manager to earn their fees.
Long-term rates factor in a variety of different expectations, including inflation and long-term economic growth. All those factors alter the calculus for long-term bonds that can have maturities of up to 30 years.
So, for the diversified portfolio of bonds shown in the graph, the impact of an interest hike could have hit some of its bonds before the actual rate change. For the long-duration, high-quality bonds, the broader trend for total return is tracking the interest rates, earning a maturity premium and reflecting market expectations for the future.
Acknowledging that market expectations affect bond prices is a more holistic way to think about how a diversified bond fund will likely perform. Just doing the bond math oversimplifies.
Bond Market: Myth and Reality
The bond market is very sophisticated and very liquid, meaning that the vast majority of factors that impact prices are priced in at any given moment, as investors constantly react to perceptions of a changing scenario.
When bonds react suddenly and sharply, it’s because news that impacts the price was unexpected (e.g., market expectations were wrong). But most of the time, market expectations are accurate, so the changes are ahead of time and gradual.
The Federal Open Market Committee (FOMC) is a group that meets about eight times a year to talk about U.S. interest rates. Looking closely at notes from a meeting in June 2015, the committee explains carefully in the official statement that interest rates aren’t decided in a vacuum, but based on the country’s reported economic data. It spells out exactly what it expects so that market expectations can be on the same page.
Required FOMC Reading
Many investors never take the time to actually read the statement, but it’s probably the most instructive few paragraphs to help answer the question of where bond prices will go. For example:
The Committee anticipates that it will be appropriate to raise the target range for the federal funds rate when it has seen further improvement in the labor market and is reasonably confident that inflation will move back to its 2 percent objective over the medium term.
What should strike any investor reading that is that if bond prices today perfectly reflect market expectations, the FOMC just spelled out the exact parameters of each of the factors that would compel the Federal Reserve to raise interest rates.
If you want to know when the Federal Reserve might raise interest rates, the answer is really clear: after more job growth and signs of rising inflation, all of which are public data released ahead of FOMC meetings.
Because bond investors knew the Fed’s framework for increasing rates, market expectations are status quo. You could read into the statement that rates might rise slightly in the medium term, perhaps at the FOMC meeting in September, which is what the prices for bonds are already reflecting could happen.
You Can’t Time Bonds
The lesson in all this is that trying to be tactical about interest rates and your bond portfolio is really a fool’s errand. If “when rates go up, yields goes up and prices go down” leads an investor to think that now is a good time to sell bonds, look at the chart again.
The dark blue line, representing the effective federal funds rate, has been at this low level for five years, and the FOMC could have decided to raise rates after any of its meetings based on the conventional wisdom that “interest rates have to go up eventually.” But it didn’t. You can be wrong for a long time.
Meanwhile, over that same time period, the U.S. Total Bond Fund, the light blue line, generated a strong return for investors in the first half of that period, and then a weaker return, but still positive, as interest rates remained at these lower levels.
If it’s reasonable to think, based on reading the FOMC statement, that the market expectations are already on the same page for a gradual rise to begin around the end of 2015 or early 2016, then the first chart will probably look like it did during the previous three periods of rising interest rates, in gray, where BND returned gains for its investors.
An investor who tried to time the market during this period by selling the bonds and holding cash, for example, would have actually lost money. Because of the impact of inflation, the investor’s real return would have been in negative territory.
Betterment Bond Basket
The bond portfolio at Betterment is the most diversified I'm aware of. We include both international developed bonds, the Vanguard Total International Bond (BNDX | B-57), and emerging market bonds, the Vanguard Emerging Markets Government Bond (VWOB | C-39), in our portfolio. This is aimed at reducing your exposure to pure U.S. interest-rate risk considerably.
Diversification is the key to creating long-term wealth in market, and a position in resilient bond funds is an important part of that, whether interest rates are rising or falling. These are the tenets of Betterment’s approach:
Diversify: Every Betterment allocation is designed to diversify risks so that you’re not overexposed to any one of them.
Lower Stock Allocations and Risk: We take the risk of different duration bonds into account in our allocations, but purely from a risk-as-uncertainty view. Our bond allocations are based on long-term views, not any short-term moves.
Always Stocks and Bonds: With the exception of 100 percent bonds, every Betterment portfolio has allocations to both stocks and bonds, international and domestic.
Lower Duration Within U.S. Bonds: As you decrease the stock slider beneath 40 percent stocks, Betterment uses ultra-short duration Treasurys to help de-risk the portfolio, which is aimed at removing your portfolio’s sensitivity to interest-rate changes, for better or worse.
Diversified Interest Rate Exposures: Also, we invest in both international developed (BNDX | B-57) and emerging market bonds (VWOB | C-39) to help diversify our interest-rate risk. This is designed so that neither of these bond funds exposes the investor to currency risk.
At the time of writing, Betterment uses BNDX and VWOB in its clients’ portfolios. Betterment is the largest, fastest-growing automated investing service, helping people to better manage, protect and grow their wealth through smarter technology. It is a CNBC Disruptor 50 and Webby award winner and has been featured in the New York Times, Forbes, and the Wall Street Journal. Learn more here.