As Published in the Fall 2013 Edition of NJ Lifestyle
In 1981, the yield on a 10 year U.S. Treasury peaked at over 15%. Over the last 30 years, fixed income investors have largely experienced a “bull market” for bonds as yields have consistently fallen, bottoming out in July 2012 at 1.53%. With the Federal Reserve taking unprecedented monetary policy action through the setting of the federal funds target rate between 0% and 0.25%, coupled with their bond purchases of $85 billion monthly, rates don’t have much room to fall further. As the Fed “tapers” their bond buying, and eventually raises the fed funds rate, what effect will investors see on their portfolios? It is widely known that as bond yields rise, bond prices will fall. An investor who purchases a hypothetical bond today yielding 2% will earn $20 of interest annually per $1,000 par value bond. If yields were to rise to 3%, an investor can now earn $30 of interest per $1,000 par value, therefore making the 2% bond less valuable, resulting in a reduction in price. Investors today face heightened interest rate risk, the risk that rising yields will make their fixed interest rate bonds less valuable, as it is inevitable rates will rise in the future.
Ben Bernanke, chairman of the Federal Reserve, raised the prospect of the fed lowering the amount of its monthly bond purchase in a June, 2013 speech. The fixed income market experienced a sell-off sending 10 year yields from just over 2% to 2.98% as of September 6. During that same time period, the iShares Core Total US Bond Market ETF (AGG) and Vanguard Total Bond Market ETF (BND) are down 3.78% and 3.71% respectively. From the July 2012 yield lows, AGG is down 6.59% while BND is down 6.91%.
Although in the short term the bond market tends to overreact to interest rate moves, it is difficult to forecast the longer term effects of a bond portfolio as several factors come in to play. Principally among these factors are how long the fed takes to raise interest rates to their target level, the size of the overall interest rate move, and the starting level of rates at the onset of the rate hikes. Since 1994, there have been three periods of rising interest rates. From 2/4/94 – 2/1/95 rates were raised 3% over a 12-month period in seven installments. During the period 6/30/99 – 5/16/00, we saw rates rise 1.75% over a 10-month period through six increases. Finally, the period 6/30/04 – 6/29/06, the Fed raised rates 17 times, resulting in a 4.25% increase over 24 months. The total returns of the Broad Bond Market, as represented by the Barclays Aggregate Bond Index, were positive 0.01%, 2.11%, and 3.09% respectively during the above periods of rising rates.
The Federal Reserve has maintained its commitment to keep interest rates low as the economy recovers, and has stated it will not begin to raise interest rates until the unemployment rate drops to 6.5%. When the Fed does start raising rates, it is widely believed they will do so in a gradual manner over a long period of time to help stabilize the markets.
One unique difference today verses the past three rate hikes, is the much lower starting yield on the 10 year treasury. The starting yields during the last three rate hikes were 5.87%, 5.78%, and 4.58%. The income earned by investors during these periods helped cushion the price declines from rising rates contributing to positive total returns. The lower yield in today’s environment may increase the likelihood investors will experience a negative total return in their traditional bond portfolios.
It is important for investors to remain diversified within their fixed income portfolios, allocating their assets among different bond categories. Floating rate, high yield, convertible, and unconstrained bond fund managers can all provide diversification benefits to the traditional government/corporate bond portfolio. Alternative asset classes such as real estate, MLPs, and commodities can add additional benefits as these asset classes carry lower correlation to both bonds and equities. It is even more important to keep in mind that rising interest rates signify the economy is improving. As seen from recent rate hikes, total returns across the Aggregate Bond Market have been positive, and although investors may initially see their principal value fall as rates rise, their overall total return when factoring in income received may not be as bad as most predict.
On the equity side, it is important to note that during the 21 periods of rising rates since 1970, the cumulative return of the S&P 500 during those periods have been positive 16 times, with eight of them positive by double digits. The worst cumulative return came during the rising rates between November 1981 and February 1982 when the S&P 500 returned a negative — 5.47%. All investors should review their current portfolios to determine whether their expected risk/reward tradeoff is in line with their financial goals.