Over the last few weeks, we have had discussions with a number of clients on why bonds should continue to be held in their portfolio during a rising interest rate environment. To explain why bonds remain a critical component in an investment portfolio, we must look at the relationship between bond prices and interest rates.
As interest rates (yields) rise in the overall economy, bond prices decline since they are inversely related. As an example, if someone holds a bond yielding 3% and interest rates increase so that yields on new bonds rise to 4%, an investor will not pay par value ($1,000 or full price) for the 3% yielding bond when they can purchase a new bond yielding 4%. Therefore, the price of the 3% bond must be discounted so that someone buying the 3% bond would receive the equivalent of a 4% yield, if held to maturity. When a bond has a duration of 1 (maturity of approximately 1 year), this would equate to a 1% drop in the price of the bond. If the bond has a duration of 10 (maturity of approximately 10 years), the price would decline by approximately 10%. This clearly illustrates the dangers of holding long-term bonds during a rising interest rate environment as their prices would decline dramatically as interest rates increase. In addition, not all bonds are created equal. Bonds vary by maturity date (short vs. long-term), credit rating (investment grade vs. high yield), domicile (domestic vs. international) and institution (corporate vs. government).
What is 1650 Wealth Management doing to protect your portfolio during a rising interest rate environment?
In the past few years, we suggested that our clients refinance their first and/or second homes to take advantage of the historically low interest rate environment. On a portfolio related note and also over the past few years, we reduced the duration of your bond mutual funds to provide some degree of protection during a rising interest rate environment. We have also utilized unconstrained mutual funds that have the ability to hedge interest rate risk as another level of protection during a rising interest rate environment. These funds provide solid diversification and a nice complement to the other bond mutual funds within your portfolio.
We have also researched the impact of a rising interest environment on the major bond index (Barclays Aggregate Bond Index). Since we have been in a declining interest rate environment since the early 1980’s, we researched the performance of the Barclays Aggregate Bond Index during the last rapidly rising interest rate environment, from 1976 to 1982, when the 10 year Treasury rate spiked from 7.74% to 14.59%. During this increase of nearly 7% or 700 basis points (see matrix below) in the yield of the 10 Year Treasury, the returns for the Barclays Bond Index remained positive throughout this time period. The reason for this was that, even though bonds dropped in value as interest rates rose, the higher yields on newer bonds made up for the drop in value. Please note that the returns during 1982 as reflected in the matrix below should be viewed as an outlier since interest rates began to decline that year which resulted in an outsized positive return for the index. While past performance is certainly no indication of future results, we felt that it would be appropriate to share the performance of the bond index during a similar time period.
Bonds are used to dampen the overall volatility and as an inflation hedge within a portfolio. As stock prices exhibit increased volatility, investors are faced with the choice of (1) holding their stock positions, (2) selling and remaining in cash or (3) investing in bonds where they can receive some sort of yield. Most investors will not remain in cash or money market accounts yielding 0.01% when they can receive higher yields in bond funds.
The media is sensationalistic in nature and has reported recently on the “flood” of money leaving bonds and bond funds. Unfortunately the media does not reveal whether the bonds being sold are long-term or short-term. It is our belief that the bonds being sold are long-term since investors are attempting to protect themselves from steep declines in the values of their portfolios. Investors who have shorter duration bonds in their portfolios may realize some small declines in the short-term as interest rates increase, but will be compensated with higher yields in the future as the bonds mature and are reinvested. Investors who sell their bond holdings and rush into stocks may be headed for a rude (and costly) awakening during any future pullbacks or corrections in the market. We shudder when the talking heads from various financial news organizations talk about investors fleeing bonds for the safety of stocks since this makes no intuitive (or financial) sense. Leaving an asset class with low historic volatility for one with high historic volatility is hardly an intelligent risk reduction technique. Hopefully, these investors have savvy financial advisors to guide them from making costly mistakes. With that being said, we remain committed to utilizing bonds within our clients’ portfolios as an inflation hedge and also as a volatility dampener.
|Barclays Cap.||10 Year||Fed|
|Year||Agg. Bond Index||Treasury *||Funds Rate|
|* As of January 1st of each year
Sources: www.federalreserve.gov, www.multpl.com, www.bogleheads.org
If you have questions on this topic or another financial topic, please feel free to call Tom Balcom at 1-800-65-9560. He would be happy to speak with you and set-up a 60-minute,complimentary no-obligation consultation to review your current investment portfolio strategy.
1650 Wealth Management is a Fee-only, Independent, Registered Investment Advisor (RIA) firm located in South Florida with office locations in both Fort Lauderdale and Miami. The Certified Financial Planners (CFP®) at 1650 Wealth Management possess over 40 combined years of investment experience, specializing in working with business owners, entrepreneurs and working professionals.