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.
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.
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.
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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.
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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.
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