7 proofs that bonds don’t always go down when rates rise

December 6, 2016 Categories: Portfolio Corner
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7 proofs that bonds don’t always go down when rates rise

The long anticipated rising interest rate environment may finally have arrived. Since the U.S. presidential election on November 8, the yield on the 10-Year U.S. Treasury Bond has risen from 1.86% to 2.39% on November 30. Anticipation of economic stimulus by the new administration appears to have driven much of that increase. But, new presidential policy is not the only catalyst for higher rates. After the 10-year U.S. Treasury yield hit a generational low post-Brexit, U.S. interest rates have progressively increased as the economy has continued to expand. The combination of growth and additional economic stimulus appear like the ingredients to make a higher rate environment come to fruition.

Although the finer nuances of fixed income investing elude most investors, they do grasp the basic concept of “when interest rates go up, bond prices go down.” This has many investors asking about their fixed income portfolio. After all, “If bond returns will be negative, why hold something that is going to lose money?” Seems like a legitimate question.

But actually: bond prices haven’t always gone down when interest rates have gone up.

Bonds: Bloomberg Barclays U.S. Aggregate Bond Index; U.S. Credit: Barclays U.S. Credit Index; Intermediate Treasury: Barclays Intermediate Treasury Index; Short Treasury: Barclays Short Treasury Index; Long Treasury: Barclays Long Treasury Index; U.S. HY: Barclays U.S. High Yield Index; Global HY: BofA Merrill Lynch Global High Yield Index; EMD: JP Morgan Emerging Markets Debt Index; Global Equity: MSCI World Index. Index returns represent past performance, are not a guarantee of future performance, and are not indicative of any specific investment. Indexes are unmanaged and cannot be invested in directly. Dates of past 7 Federal Reserve interest rate hike periods: July 1980 – June 1981; February 1983 – August 1984; October 1986 – October 1987; March 1988 – March 1989; December 1993 – April 1995; May 1999 – June 2000; May 2004 – July 2006.

Bonds: Bloomberg Barclays U.S. Aggregate Bond Index; U.S. Credit: Barclays U.S. Credit Index; Intermediate Treasury: Barclays Intermediate Treasury Index; Short Treasury: Barclays Short Treasury Index; Long Treasury: Barclays Long Treasury Index; U.S. HY: Barclays U.S. High Yield Index; Global HY: BofA Merrill Lynch Global High Yield Index; EMD: JP Morgan Emerging Markets Debt Index; Global Equity: MSCI World Index. Index returns represent past performance, are not a guarantee of future performance, and are not indicative of any specific investment. Indexes are unmanaged and cannot be invested in directly. Dates of past 7 Federal Reserve interest rate hike periods: July 1980 – June 1981; February 1983 – August 1984; October 1986 – October 1987; March 1988 – March 1989; December 1993 – April 1995; May 1999 – June 2000; May 2004 – July 2006.

Indeed, as shown in the chart above, in the past seven Federal Reserve interest rate hike cycles, average bond returns have been positive – not negative. Of course, the returns were lower than long-term historical averages and there were some significant downturns, with emerging markets debt (EMD) suffering the most, but otherwise most segments of the fixed income market had modest positive average returns, in the single digit range.

In addition, global equity returns outpaced their historical norms during these rising interest rate periods, as the chart reflects. This shouldn’t come as a complete surprise, given that interest rates generally increase during positive economic periods and these environments tend to translate into positive equity market returns.

Of course, these historical results do not guarantee a positive return ahead for bonds – but, by the same token, they demonstrate that a negative return is not a certainty either. Considering that the Bloomberg Barclays U.S. Aggregate Bond Index is down -3.1% since the start of October (thru November 30, 2016), much of the near-term damage in bonds may already be behind us.

Additional considerations for those questioning the role of bonds in the portfolio:

  • Interest rate movements are very difficult to predict.
    Going into 2016 many expected to see a gradual rise in rates. The actual experience has been a roller coaster ride with rates just now exceeding the starting point for the year. Since January 1, 2016, the Bloomberg Barclays U.S. Aggregate Bond Index has returned 2.5% as of November 30, 2016.
  • Bonds are more attractively priced today than they were four to five months ago.
    Interest rates on the 10-Year U.S. Treasury have moved up over 1% since their post-Brexit July low of 1.37%, making them more attractively priced now than they were in July – a time at which few were suggesting abandoning bonds. So, don’t let recent market moves outweigh long-term investment plans.
  • As interest rates rise, so do coupon payments.
    The higher level of interest rates today creates a greater coupon “cushion” for bond investors against rising rates going forward. This is also helpful for investors seeking income, who will experience a significant pick-up in yield from the bond portfolio at these higher rate levels.
  • Bonds remain a good diversifier to equities.
    Bonds will continue to serve their primary role as diversifier for the equity portion of multi-asset portfolios. Investors will be thankful for the presence of bonds within the portfolio when volatility spikes in equity markets.

The bottom line

It appears that the long-anticipated rising rate environment may be upon us. Many investors are conditioned to assume that rising interest rates spell trouble for bonds. It’s true: there is an opposite relationship between interest rates and the price of bonds. However, rising rates don’t guarantee that bond returns will be negative in these environments. Reviewing past periods of rising interest rates reveals that bond returns were muted on average, but not negative. Considering that the bond market has already retreated just over 3% since the start of October through November 30, it’s possible that forward-looking bond expectations may be muted, but not necessarily negative. While this may not thrill bond holders, bonds are likely to help cushion their portfolio from the impact of potential volatility in equity markets.

Disclosures:

These views are subject to change at any time based upon market or other conditions and are current as of the date at the top of the page. The information, analysis, and opinions expressed herein are for general information only and are not intended to provide specific advice or recommendations for any individual or entity.

This material is not an offer, solicitation or recommendation to purchase any security.

Bond investors should carefully consider risks such as interest rate, credit, default and duration risks. Greater risk, such as increased volatility, limited liquidity, prepayment, non-payment and increased default risk, is inherent in portfolios that invest in high yield (“junk”) bonds or mortgage-backed securities, especially mortgage-backed securities with exposure to sub-prime mortgages. Generally, when interest rates rise, prices of fixed income securities fall.  Investment in non-U.S. and emerging market securities is subject to the risk of currency fluctuations and to economic and political risks associated with such foreign countries.

Forecasting represents predictions of market prices and/or volume patterns utilizing varying analytical data. It is not representative of a projection of the stock market, or of any specific investment.

Nothing contained in this material is intended to constitute legal, tax, securities or investment advice, nor an opinion regarding the appropriateness of any investment, nor a solicitation of any type.

Please remember that all investments carry some level of risk, including the potential loss of principal invested. They do not typically grow at an even rate of return and may experience negative growth. As with any type of portfolio structuring, attempting to reduce risk and increase return could, at certain times, unintentionally reduce returns.

The general information contained in this publication should not be acted upon without obtaining specific legal, tax and investment advice from a licensed professional.

The information, analysis and opinions expressed herein are for general information only and are not intended to provide specific advice or recommendations for any individual entity.

Indexes are unmanaged and cannot be invested in directly. Returns represent past performance, are not a guarantee of future performance, and are not indicative of any specific investment.

Bloomberg Barclays U.S. Aggregate Bond Index: An index, with income reinvested, generally representative of intermediate-term government bonds, investment grade corporate debt securities, and mortgage-backed securities.

Barclays U.S. Credit Bond Index: Measures the performance of investment grade corporate debt and agency bonds that are dollar denominated and have a remaining maturity of greater than one year.

Barclays Intermediate Treasury Index: Measures the performance of U.S. Dollar denominated U.S. Treasuries, government-related and investment grade U.S. corporate securities that have a remaining maturity of greater than one year and less than ten years.

Barclays Short Treasury Index: Is composed of all treasuries that have a remaining maturity between one and twelve months.

Barclays High Yield Municipal Bond Index: An unmanaged index considered representative of noninvestment-grade bonds. FactSet Research Systems Inc. Barclays Intermediate U.S. Credit Index is an unmanaged index of dollar-denominated, investment-grade, publicly issued securities with maturities of one to 10 years.

BofA Merrill Lynch Global High Yield Index: Tracks the performance of USD, CAD, GBP and EUR denominated below investment grade corporate debt publicly issued in the major domestic or Eurobond markets.

JPM Emerging Market Bond Index (EMBI): dollar-denominated sovereign bonds issued by a selection of emerging market countries.

MSCI AC World ex-U.S. Index: The MSCI All Country (AC) World ex U.S. Index tracks global stock market performance that includes developed and emerging markets but excludes the U.S.

Russell Investments’ ownership is composed of a majority stake held by funds managed by TA Associates with minority stakes held by funds managed by Reverence Capital Partners and Russell Investments’ management.

Frank Russell Company is the owner of the Russell trademarks contained in this material and all trademark rights related to the Russell trademarks, which the members of the Russell Investments group of companies are permitted to use under license from Frank Russell Company. The members of the Russell Investments group of companies are not affiliated in any manner with Frank Russell Company or any entity operating under the “FTSE RUSSELL” brand.

The Russell logo is a trademark and service mark of Russell Investments.

Copyright © Russell Investments 2016. All rights reserved. This material is proprietary and may not be reproduced, transferred, or distributed in any form without prior written permission from Russell Investments. It is delivered on an “as is” basis without warranty.

Russell Investments Financial Services, LLC, member FINRA (www.finra.org), part of Russell Investments.

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