January 24, 2012
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Thirty-one years ago, in 1981, the one-year Treasury reached its all time high of 14%. Today it hovers around 0.10%. Never before have interest rates fallen so far. Many economists and investment advisors, seeing nowhere to go but up, expect interest rates to climb from these historic lows. But that would not be the catastrophe that many bond investors fear.
The conventional belief is that an interest rate increase would harm bond investors. That fear is understandable. When interest rates go up, bond prices go down, and bond investors lose. From most investment industry professionals, the talk is not if but when. To pick one particularly egregious example, consider the alarm sounded recently by Investment News, under the ominous heading: “Disastrous Bond Rout Just Up the Road, Experts Warn” The article cautioned that “even a puny rise in interest rates will slam current holders of US debt” and said there was a ”high probability” of an “inflationary shock.”
In contrast to these shrill warnings, my research tells a different story.
Setting aside the conventional wisdom about bond prices and yields and stepping into the real world, with history as a guide, I find that diversified bond fund investors may profit long term, even in the face of rising interest rates.
Looking to history
To evaluate the outlook for bonds, I measured how bond mutual funds and indices performed when interest rates rose. This is not easy to do because few of us have experienced any prolonged rise of interest rates.
How did investors do during rising interest rates? There is little data. Of the 4,227 taxable bond funds today, only five had an inception date before 1960 (the relevant rising interest rate period). How did these five perform? This may surprise you. The five funds’ average annual return from 1963-1981, a 19-year period when interest rates rose more than threefold, was 4.15%.1. An equal-weighting of the only five taxable-bond funds available then and now, during those 19 years – the worst run-up in interest rate history – would have doubled.
One of the five funds lost money for the 19-year period; another made less than a 1% annual return. Nevertheless, these were all of the funds that were available that are live today.
What about survivorship bias? Since our investment assumption period reaches back almost 50 years, can we assume that there were other bond funds in which one could have invested that might have skewed these results? According to Blake, Elton, and Gruber there were as many as 46 taxable bond funds in 1979.2 (There were likely fewer than 46 that existed for the entire 1963-1981 period I tested.)
The number of bond funds grew dramatically during the 1980s, from 84 in 1978 to 914 in 1990.3 This should not be a surprise, given that interest rates peaked in 1981. By then, bonds became a very attractive investment option and fund managers seized the opportunity with the launch of more upon more bond funds.
So it is true that many bond funds have come and gone since the time period I studied, and many that existed in that era have since shuttered. Edwin Elton and Martin Gruber, however, have argued that “survivorship bias is less important for bond funds than it is for stock funds since bond fund performance is less variable…” A major bond fund study conducted by Elton, Gruber, and Christopher Blake in 1995 concluded that a reasonable survivorship factor for bond fund returns was 27 basis points per year.4 If our bond funds returns are discounted by the normative bond survivorship bias factor (or even by significantly more), the results do not change: Long-term aggregate bond fund returns were positive during steeply rising rates, even after adjusting for potential survivorship bias.
Fund source: Morningstar Advisor Workstation. May 14, 2011 and corrected August 2, 2011Performance data source: Yahoo! Finance and Morningstar, Inc. (We could not find performance data for all five funds pre 1963.)
2. The Performance of Bond Mutual Funds, Christopher R. Blake, Edwin J. Elton and Martin J. Gruber, The Journal of Business, Vol. 66, No. 3, The University of Chicago Press, Jul., 1993 (http://www.jstor.org/stable/2353206), p. 373
3. Fundamental Economic Variables, Expected Returns, and Bond Fund Performance, Edwin J. Elton; Martin J. Gruber; Christopher R. Blake, The Journal of Finance, Vol. 50, No.4. (Sep., 1995), p. 1237
4. Fundamental Economic Variables, Expected Returns, and Bond Fund Performance, Edwin J. Elton; Martin J. Gruber; Christopher R. Blake, The Journal of Finance, Vol. 50, No.4. (Sep., 1995), pp. 1247-48.
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