Since the early 1980s, bond investors have benefitted from declining interest rates. But we may be turning to a future of rising rates and clients suffering bond losses. Advisors need to be prepared both in terms of investment strategy recommendations and communication with clients.
The presidential election may have provided a preview of things to come. On Election Day the 10-year Treasury bonds were yielding 1.88%, but by mid-December yields had increased 72 basis points to 2.60%. Inflation-protected securities (TIPS) saw an increase of 55 basis points over the same period. For the 4th quarter of 2016 bond funds posted losses. The Vanguard Intermediate-Term Treasury fund (VFITX) lost 3.42% and their intermediate-term corporate bond fund (VICSX) lost 3.39%. There was less impact on Vanguard Inflation-Protected Securities, down 2.69%.
Yields have leveled off since year-end. Should we expect yields to remain at current levels, which are well below historical averages, or should we expect further increases? The general consensus among investment managers and economists is that we are on an upward trend. Jeffrey Gundlach, in this post-election Barron’s article, predicted that the 10-year Treasury will hit 6% in the next four to five years. Bill Gross predicted increases, but not as steep. He expects continued rate repression from international central banks to dampen increases. The latest Wall Street Journal monthly survey of more than 60 economists predicted the 10-year Treasury at year-end yielding 2.86% and a further increase to 3.10% by the end of 2018.
If we are indeed on an upward trend, clients will be seeing more bond losses.
Misconceptions
It’s only natural for clients to view that:
- The Fed controls interest rates, both short-term and long-term;
- Market-value losses on bond portfolios are bad; and
- Advisors should be able to avoid such losses.
Given the complex nature of fixed income markets, it’s certainly understandable why many would hold such beliefs. Unfortunately, these beliefs are not easy to counter. Building better client understanding requires explaining the subtleties of the bond market.
Regarding the Fed, my own clients have at times asked this question: “I’ve heard the Fed will be raising rates – shouldn’t we do something?” To address this concern it is useful to look at the relationship between Fed actions and longer-term interest rates. Unfortunately, we have only limited experience of Federal Funds rate increases while Janet Yellen has been chair, although we certainly expect more this year. That limited experience has demonstrated a disconnect between moves in the Funds rate and rates for longer maturities. On December 16, 2015 the Fed raised the Funds rate from the 0% - 0.25% range to 0.25% - 0.50%. The day before the rate increase the 10-year Treasury yield was 2.28% and the day after at 2.24%. The yield dipped as low as 1.37% in mid-2016 before the increasing later in the year.
On December 14, 2016 the Fed did another Funds rate increase to the 0.50% - 0.75% range. There may have been a slight impact on longer maturities with the 10-year Treasury rising from 2.48% the day before to 2.60% the day after, but rates then dipped slightly for a few months. The most recent increase was on March 15, 2017 and the yield dropped from 2.60% to 2.52% when the Fed made the announcement.
The Fed does indeed control the Federal Funds rate and this rate influences other short-term yields. However, any influence of the Fed on longer maturities is much more tenuous.
But even without a direct Fed connection, we do have forecasts of longer-term rates increasing. Bond mathematics dictate that when rates go up, bond portfolios show losses, as with the 4th quarter Vanguard results mentioned above. When clients see losses on their investment statements they may naturally ask, “Why do you have me in investments that lose money?” This is more of a challenge to address than the Fed connection, and requires taking a closer look at the information investment statements provide.
Let’s say a client had $100,000 invested in the Vanguard Intermediate-Term Treasury fund (VFITX) on September 30, 2016. At the end of the year, the value on the investment statement decreased to $96,580 reflecting a 3.42% loss. But the statement loss was only half the picture – on 9/30 the client had $100,000 earning 1.14% and on 12/31 that value indeed dropped to $96,580 but the portfolio was then earning 1.93%. “Loss” is a bit of a misnomer because the portfolio consisted of essentially the same bonds on 9/30 and 12/31, they were earning the same coupons, and the U.S. government had not defaulted on its obligations. The value was restated to reflect the increase in market interest rates. Unfortunately, this explanation may convince investment professionals, but not clients, who may say, “The investment statement simply says I lost money, and if interest rates keep going up and you keep me in this fund, I’ll lose more money.”
Another approach for clients seeking a fuller explanation is to show the impact on their overall financial plan, which I discussed in this 2013 Advisor Perspectives article. A further reason why investment statements are incomplete is that they leave out half the balance sheet – they show assets but not liabilities. For retirees or those planning for retirement, the liability side can be thought of as the present value of retirement spending obligations. Typically those obligations fall much further into the future than the coupon and principal repayments from bond portfolios. The effect of an interest rate increase is that, as bond proceeds are reinvested at higher rates, more income is generated to meet retirement obligations, so projected financial outcomes improve.
A more technical explanation is that duration of the liabilities is longer than the duration of bond portfolios, so an increase in interest rates reduces the present value of liabilities by more than the decrease in the market value of bond assets.
Clients are better off financially if interest rates increase than if interest rates stay level. Providing this more complete picture may help, but don’t be surprised if the response remains, “But my investment statement still shows I’m losing money.”
What clients really want
From a client perspective, the ideal fixed income manager would be one who avoids losses by adroitly timing interest rate moves – lessening duration before rate increases and then increasing maturities when rates flatten out. Unfortunately, being able to accomplish this feat on a consistent basis amounts to market timing, which is notoriously difficult to do well on a consistent basis.
In order to develop a better understanding of the challenges such an ideal manager would face, let’s take a historical period when rates were generally rising and examine the month-by-month bond yield changes. The goal is to get a better feel for the environment in which such a manager would be operating. To do this I obtained monthly average yields for 10-year Treasury bonds from the St. Louis FRED data base for the period 1962 through 1977. Over this period, Treasury yields increased by about 360 basis points from 4.08% at the beginning of 1962 to 7.69% at the end of 1977. I segmented the 16 years into blocks of months where there were consecutive increases or decreases in yields and measured average increases and decreases in these blocks as well as the duration in months. The following chart shows the results.
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10-year Treasury bonds--yield changes 1962 - 1977
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Description
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For increases
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For decreases
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Average consecutive months
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2.6
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2.0
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Average change (basis points)
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36
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-27
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Consecutive months
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Increase count
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Decrease count
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1
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12
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22
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2
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11
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11
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3
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10
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4
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4
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4
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3
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5
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2
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0
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6
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0
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0
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7
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1
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2
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8
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1
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0
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Total
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41
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42
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Source: St. Lois Fed FRED
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The top two lines of the chart show that, although increases naturally dominated, the average increase only lasted 2.6 months, not that much longer than the average 2.0 months for decreases. The magnitudes of change were not significantly different either. The bottom part of the chart shows the distribution of consecutive months of increases and decreases, with a lot being concentrated in the one- to two-month range. The increases tended to be a bit more sustained, but not hugely different.
Now consider a manager operating in this environment – attempting to avoid losses when interest rates increased, but not being caught short and missing opportunities for increased returns when rates went the other way. Retrospectively, it might be easy to understand what happened over this 16-year period, but one can hopefully appreciate how confusing it would have been during these times trying to predict where rates were going next. There may be fixed income managers who are able to successfully anticipate long-term trends, but it’s likely they will still get caught producing market value losses from time to time, and these will need to be explained to clients.
What to do
With a better appreciation of the challenges, we can now consider strategies for dealing with rising rates. Below is a list of options I have developed, with brief comments on each. Note that some of these fall outside of traditional bond management.
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Stay in short-term bonds: Eliminates losses, but gives up the average return spread of long-term over short-term bonds – historically close to 200 basis points (Treasury bonds over Treasury Bills from Ibbotson data).
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Choose funds managed by a tactical manager with a good track record: Great if the track record continues, which is unlikely, in which case clients incur the performance drag of the fund manager and advisor expense charges.
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Go to lower credit quality bonds, dividend stocks or real estate funds: A plus is that the income may be enough to offset statement losses from interest rate increases. A negative is that credit losses on these investments will likely correlate with periods where the stock market is performing poorly.
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Recommend balanced funds: An advantage is that the mix of stocks and bonds may conceal market value losses on the bond portion. However, this article shows that many of these funds have performed poorly.
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Utilize bond ladders: Can help with client communication, particularly in the withdrawal phase of retirement. (Can assure clients that, “the retirement income will be there regardless of what happens to interest rates.”) Keeping the cost of laddering down is important.
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Invest in stable value funds: Many 401(k) plans offer such funds that protect principal. Benefits are more cosmetic than real because returns lag when interest rates go up, but there is an option to bail out at par.
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Delay Social Security: This delay strategy provides a way to generate bond-like inflation-adjusted lifetime income at an attractive tradeoff of increased benefits versus Social Security income given up during the delay.
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Purchase a single-premium immediate annuities (SPIA): Provides a fixed income-like investment with the additional advantage of longevity pooling. Does not show statement losses when interest rates increase. The downside is lack of liquidity.
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Buy and hold high-quality intermediate- or long-term bond funds: May be best bond strategy for long-term client financial outcomes, but will experience periodic market value losses.
I don’t recommend strategies 1 – 3, although I realize there will many who favor using active bond managers. My main concern with active managers is the yield hit from expenses, both for the active managers and for advisors selecting and monitoring the managers. How things look to clients can be very important and I view strategies 4 – 6 as ways of reducing potential client concerns or harmful bailout behavior. Whether these strategies provide actual financial benefits is subject to debate. I’m a fan of strategies 7 and 8 – the idea being to build secure lifetime income to cover essential retirement expenses and improve retirement outcomes. (The benefits from delayed Social Security and SPIA purchase are illustrated in this New York Times article.) Strategy 9 offers the best approach for any fixed income investing needed after Social Security delay and annuity purchase. An additional advantage of utilizing strategies 7 and 8 in a rising rate environment is that they provide bond substitutes so regular bond investing with the downside of periodic statement losses can be reduced.
A better way forward
We’ve identified investment statements as the culprit affecting client communications because they provide a misleading and incomplete picture of bond portfolios. Clients need a more complete financial planning assessment to take their focus away from the narrow view of only looking at bond portfolio market values. I addressed the general issue of improving information for clients in some detail in this 2016 Advisor Perspectives article. The need for better information becomes more important as clients move from accumulation to retirement. Technology will be key to providing a more complete picture and to making instantaneous updates available.
Joe Tomlinson, an actuary and financial planner, is managing director of Tomlinson Financial Planning, LLC in Greenville, Maine. Most of his current work involves research and writing on financial planning and investment topics.
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