January 24, 2012
There is also one caveat to my finding that total return grows over time even amid rising rates: The return recovery after a rate shock depends on a long compounding period. Since interest rates have historically taken a long time to rise, however, I believe I am being realistic.
Finally, it is imperative to distinguish between short- and long-maturity bonds. Nothing I have said about 10-Year Treasurys would apply to 30-Year Treasurys. The 10-Year Treasury held up well in the worst bear market for bonds in history, but 30-Year Treasurys were a poor investment. I tested rising interest rates against bond funds, not coupon bonds. I have also assumed a widely diversified, equally weighted, portfolio of bond funds. One fund type is not enough.
Those are all reasons to take my findings in proper context, something that is sorely lacking from many of the warnings on the other side of the argument. Remember the article I cited earlier that argued that “even a puny rise in interest rates will slam current holders of US debt”? That article asserted that, if yields on Treasury Bonds rise just 3%, 10-Year Treasurys will decline 23.5% and 30-Year Treasurys will drop 40.7%. The problem with this is rates would have to rise 3% in one year. Rates have never come anywhere close to rising 3% in one year – 3% is not “puny.” It is absurd to make such a historically improbable estimate – much like saying that all the polar ice fields will melt if temperatures rose 3 degrees overnight. This may be true, but the fact that temperatures have only increased one-half degree Celsius in the last 100 years should restrain such wild predictions.
In each instance of rising interest rates that I studied or modeled, except for those from what some would call a tail event, the total return of a bond portfolio was positive in a rising rate environment. A tail event, something outside of expected range, would be the doubling of 10-Year Treasury bond rates within a period of 10 years, which has only happened twice in history (1972-1981 and 1973-1982). Over a five-year period, 10-year Treasury rates have never doubled. But even if that were to happen, a doubling of 10-Year Treasurys was positive in our models. The quickest that 10-Year Treasury rates have ever tripled was in 16 years, from 1967-1982. If rates tripled over the next 16 years, our models still predict a positive total return.
Art or science?
After what equity investors have suffered through in the last 10 years, we might excuse the industry for issuing dire warnings, even if a few prove to be false alarms. But it is dangerous for these warnings to be so unrealistic that the investor reacts in a self-destructive manner. These warnings teach a yield-to-crisis mentality to investors, who may overreact and avoid bonds completely or make risky bets on speculative leveraged and derivative bond products that are untested in rising rate environments. Is it a coincidence that the dire warnings often come from the same people who are developing these speculative investment products?
Moreover, these warnings gloss over the basic fact that the returns for bonds and stocks behave differently in essential ways. Long-term the average returns and standard deviation for intermediate Treasury Bonds and Treasury Bills are roughly equal, whereas, the standard deviation for stocks is roughly twice their average return. Perhaps only with bonds can you accurately state that risk equals reward. That is good news for bond buyers; it says that overall there are few surprises in either a bull or bear market.
A final word on investment models: Some analysts suggest colorfully that stocks are an art, and bonds are a science. Neither is quite true. Investment analysis will always be best-informed when it comes from historians, not artists or scientists. We are most reliable when we identify recurring or reversing trends, which is precisely what I have attempted here.
In conclusion
Rising interest rates are not what bond investors would, in an ideal world, prefer. During the 29-year declining rate environment from 1982-2010, the five bond funds whose example I looked to produced predictably better annual performance than they had in the rising rate environment – 7.85% annually versus 4.15% annually – and the real returns for bonds were significantly higher from 1980-2010 than from 1950-1980.
What lessons should you take away from my research?
- History is on the side of bond investors, even in a rising rate environment;
- The low historical variability of returns for bonds means past bear markets were much easier on bond buyers than is commonly thought;
- Interest rate increases have unfolded gradually;
- Since interest rate increases have been slow, rising interest income will outweigh the loss in principal value;
- Maturities should be shortened in a rising rate environment;
- Bond funds may perform better than individual bonds during rising rates, because of the ability to reinvest funds at progressively higher interest rates;
- Diversification across bond issuers, sectors and maturities is vital during a period of rising rates; and
- Avoid experimenting with untested products or strategies during rising rates.
For the diversified bond fund, bond index or balanced fund investor, rising interest rates are simply not the looming catastrophe they have been made out to be.
Andrew D. Martin is president of 7Twelve Advisors, LLC, an SEC registered investment adviser, and a registered principal for Girard Securities, Inc., a San Diego based broker/dealer. He holds the series 7, 24, 53, 63 and 66 licenses.
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