Rising Interest Rates Could Spell Trouble for Bond Funds

April 12, 2013 (PLANSPONSOR.com) - Interest rates have continued to fall since the start of the financial crisis in 2008, with the yield on the 10-year Treasury declining from around 4% to an all-time low of just 1.5% last summer.
By PS

The Federal Reserve’s ultra accommodative monetary policies and their concerted efforts to drive yields lower, through unprecedented purchases of trillions of dollars of bonds, have been aimed at propping up the ailing U.S. economy. With interest rates still hovering near rock bottom lows, and the economy beginning to show signs of life, many investors are asking if the bull market run in bonds is now over.    

Bonds have generated strong returns    

As shown in the chart below, 2012 ushered in another stellar year of bond market performance, led primarily by gains in the high yield and emerging market sectors, as the global appetite for yield and spread product continued unabated. 

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Performance over the last few years was also comparably stellar, despite a few hiccups along the way. But, we may be reaching a point where the recent rip-roaring returns in many bond market sectors could be coming to a screeching halt. We think investors must take heed the warnings of long-time bond veterans, such as Dan Fuss from Loomis Sayles or Bill Gross from PIMCO, that certain bond sectors have become overvalued or exuberantly priced. 

The next big move in bonds    

A glimpse at history puts the recent decline in interest rates into perspective. The chart below shows an interesting pattern in the path of U.S. 10-year Treasury yields over the last 50-plus years. During the first half of the period, from the late 1960s until the early 1980s, we witnessed a long era of rising interest rates, which was subsequently followed by another 30-year stretch of falling interest rates. We are clearly at a critical inflection point.    

While the U.S. economy is still facing some strong near-term headwinds, such as fiscal challenges and below-trend economic growth, the next big secular move in interest rates is likely to be higher. The challenge is no one can predict the exact timing of when the rate cycle will eventually turn, or how far rates will rise once they begin to march higher. In order to prepare for this coming shift, it is important for investors to review the fixed income exposures in their retirement portfolios. If history offers any guidance, the transition is likely to be bumpy. 

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Impact of rising rates on fixed income returns    

In this low interest rate environment, many people have underappreciated the bond risks in their portfolios. Going forward, the price risk, volatility and performance of this traditional safe-haven investment may be dramatically different from past rising rate environments. 

To understand how your portfolio may be impacted, let’s review how bond investments work. Bond yields have an inverse relationship with prices, meaning prices rise in value when interest rates fall and fall in value when interest rates rise. In essence, rising interest rates and inflation are to bonds what kryptonite is to Superman. At current interest rates, bond investors run the potential risk of suffering large losses on their investments when the rate cycle inevitably begins to reverse course.    

To illustrate, the chart below shows a snapshot of the price impact that an immediate 1% rise or fall in interest rates would have on the principal value of a bond investment across different maturity and credit spectrums. As you can see, the price impact or risk is greater for bonds that have longer maturities. Therefore, if rates were to suddenly rise by 1%, a 30- year U.S. Treasury bond would suffer an immediate 20% loss. This is certainly not the type of performance the average investor would expect from one of their core bond holdings. 

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It is also important to understand that a bond’s total return is comprised not just of price changes, but also of income. Therefore, the income received will help offset the loss caused by falling values, providing a cushion on the overall total return of an investment. But with rates so low across various sectors of the bond market these days there is very little income left to absorb the price losses when rates eventually begin to move higher.    

Future bond returns will be more muted    

With rates on U.S. government securities ranging from 0.10% on 3-month bills, to just over 3% on 30-year bonds, the math behind generating the fixed income returns of recent years is unlikely to be repeated. Since yields on the short-to-intermediate part of the bond market are hovering very close to their zero-bound floor, it is becoming abundantly clear the price appreciation that has buoyed returns in prior years has largely run its course. That’s not to say bonds still can’t generate positive returns, it simply means the total return will more likely be driven by the income component, or yield, the bond earns. It also means investors should expect little in the way of price appreciation from falling yields going forward; and when rates do begin to rise investors can actually lose money on their bond investment.    

While bonds have been a magnificent investment through much of the last decade, performance may be much more muted or even negative in the years ahead. Since the economic recovery is still very fragile, investors should use this time as an opportunity to prepare their fixed income portfolios for an eventual rise in interest rates. A well diversified portfolio, which focuses on asset classes with less interest rate sensitivity or shorter durations, can help your fixed income allocation navigate safely when the rate cycle ultimately turns.    

   

Tracey M. Manzi, CFA Vice President, Investment Services, Cammack LaRhette Consulting    

NOTE: This feature is to provide general information only, does not constitute legal advice, and cannot be used or substituted for legal or tax advice. 

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