The number-one question I get from investors is, “When will rates go up?” While this concern has been top of mind for the last few years, investors’ anxiety and sense of risk has intensiﬁed amid the threat of the “Great Rotation”—the anticipated en masse reallocation out of bonds into equities. But so far, rates have yet to rise, leaving many people to wonder where we stand now and what may happen next. To answer these questions, I’d like to make three points:
- Why interest rates could remain low
- Why investors may be better protected than they realize if and when rates do rise
- Why it’s important to redesign rather than abandon a ﬁxed-income allocation
Why Rates Could Remain Low
When people think about historical interest rates, they tend to look back only at the last 35 years or so, starting with the soaring rates of the 1980s, which have since fallen over time. But if we extend our analysis over the last 100 years, we see that 10-year Treasury yields hovered between 2% and 4% fromthe mid-1920s to the mid-1960s (Figure 1). It is particularly interesting to focus on the decade immediately following World War II. As a result of the astronomical costs associated with ﬁnancing America’s participation in World War II, the US debt-to-GDP1 ratio rose to 130%. However, the Federal Reserve capped interest rates to protect the assets of US citizens who supported the war effort by buying war bonds and to control the government’s interest expenses. While there are many differences between the World War II era and today, precedence for an extended period of low rates exists, and the Fed’s inﬂuence should not be underestimated.
In the current context, we can’t talk about rates without discussing the Fed’s cautious stance, which is based on its perception of a fragile US economic recovery. The Fed has been transparent about communicating its conditions for maintaining an accommodative stance: an unemployment rate above 6.5% and inﬂation expectations below 2.5%. After a strong start to the year, recent data on manufacturing and GDP have come in lower than forecasted. Concern still looms about the impact of the sequester, and inﬂation expectations, as observed in 10-year Treasury Inﬂation-Protected Securities(TIPS) are yielding 2.3%—down from 2.5% at the beginning of the year.* As much as the markets would like to see evidence of an exit strategy, the Fed stated on May 1 that it’s “prepared to increase or reduce the pace of its purchases,” depending on the strength or weakness of the economic outlook. In short, all signals from the Federal Open Market Committee leadership indicate that the Fed will remain highly accommodative for the foreseeable future.
*Source: Bloomberg 5/13.
Why Investors May Be Better Prepared Than They Think
Notwithstanding potential action from the Fed, bond markets do face asymmetric risk given the low level of interest rates. Moreover, falling rates have actually increased the duration, or interest-rate sensitivity, of bonds. So how worried should investors be about negative returns on bonds? It all depends on the duration of the bonds in a portfolio. The math is fairly simple: If an investor owns a 10-year bond with nine-year duration, a 1% spike in rates would generate an immediate loss of about 9%. That is certainly a bad outcome. However, looking at shorter-duration bonds and longer investment horizons, the results are quite different—and not nearly as disturbing. Figure 2 shows the difference time horizon makes on an investor’s experience. Even the near-term loss from a quick, 1% spike in interest rates will be recovered over time due to accumulating coupon income at higher rates. Assuming a bond portfolio with a duration of four years and an initial yield of 1.7%, after almost two years, the investor breaks even; after ﬁve years, the annualized return is 1.8%. If we double the rate rise to a 2% spike, the initial loss is more severe, but the higher coupon offsets this over time; the investor will recover the loss in two-and-a-half years.
Looking at this issue more broadly, Figure 3 shows 10-year US Treasury yields and ﬁve-year forward returns since1900. Investors have experienced just two periods of negative ﬁve-year returns: one following 1954 when yields were about as low as they are today, and again in 1976,amid rising inﬂation. In both cases, losses were less than 1%on an annualized basis for the period. As long as investors have some exposure to shorter-duration bonds and maintain investment horizons long enough to recover losses, they may be in better shape than they think—even if rates do rise in the short run.
Another reason why higher rates may not cause extensive losses for many people is that diversiﬁed investment portfolios typically contain assets that respond positively to rising rates, particularly if the impetus for higher rates is stronger economic and corporate earnings growth expectations. For example, in a portfolio with an allocationof 70% equities/30% bonds, the potential increase in equity returns during a growth-fueled increase in inﬂation could more than offset the losses from the bond allocation incurred from higher interest rates. However, during a period of stagﬂation, marked by weak growth and rising inflation, both the equity and bond allocations could sufferblosses.
Why Investors Should Not Abandon Bonds
While today’s low starting yields suggest low projected returns (as Figure 3 suggests), I believe high-quality bonds play a vital long-term role in almost any diversiﬁed portfolio. As an asset that performs best in a weak-growth environment, these bonds provide protection that cannot be replicated by any other asset class.
I do recommend that investors protect themselves against rising interest rates given the asymmetric risks that bondholders face. Clearly, interest rates are at rock-bottom levels and strategies that incorporate less-interest-rate- sensitive assets are prudent. But investors should not necessarily assume that rising rates are imminent or even deﬁnite. Important counterweights to the rising-rate argument include the tenuous US economic recovery, still- weak global macro environment, and the accommodative bias of major central banks, including the Fed, the European Central Bank, Bank of England, and Bank of Japan. Given the many policy what-ifs and the important evergreen function of bonds in an investment portfolio, I recommend a balanced strategy preserving ﬁxed-income allocations for their unique ability to perform well when equities do not.
- Shorten or hedge duration risk. Investors may want to consider adding exposure to short-term bonds and reducing exposure to longer-duration bonds that carry more interest-rate risk.
- Diversify ﬁxed-income allocations. In addition to shorter-duration bonds, investors can increase exposure to ﬁxed-income sectors such as bank loans or high-yield bonds that have less interest-rate sensitivity than Treasuries. Investors should be aware, however, that this involves taking on more credit risk and increases the correlation of the bond portfolio to equities.
- Think opportunistically. Incorporating absolute-return and/or opportunistic strategies in which portfolio managers have more duration and sector-rotation ﬂexibility can be yet another way for investors to fare better than benchmark-relative strategies in a rising- or ﬂuctuating-rate and spread environment.
1 The Gross Domestic Product (GDP) is the monetary value of all the finished goods and services produced within a country's borders in a specific time period.
All investments are subject to risk, including the possible loss of principal. Investments in bonds are subject to interest-rate risk (the risk that the value of an investment decreases when interest rates rise) and credit risk (the risk that the issuing company of a security is unable to pay interest and principal when due) and call risk (the risk that an investment may be redeemed early). Diversification does not ensure a proﬁt or protect against a loss in a declining market.
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