You may have noticed that interest rates around the world have generally moved higher over the last few months. Predictably, this has encouraged certain investment “gurus” to issue increasingly vocal warnings to fixed income investors to “sell now!” or face heavy losses. A “bond bear market” is right around the corner they say! Is there any reason to listen to these prognosticators? Or to re-phrase the question a bit, does it still make sense to hold bonds in a rising rate environment?
Now the astute reader will notice a small asterisk at the end of the word “Environment” in the title of this month’s post. That’s because we need to make a small disclaimer right here – we really have no idea if we are in a “rising rate environment” or not. While interest rates have been gradually rising over the last few months, we simply can’t say whether that will continue or reverse course in the near future. In fact, the yield on the ten-year US Treasury bond (2.63%) is now just back to the level it reached on December 16, 2016, about 13 months ago. So maybe we are just in a flat yield environment. But just as a thought experiment, let’s assume that rates will keep rising over the next few months or years – in that case, does it still make sense to hold bonds in your portfolio?
Before we address that question, it would be helpful to review why bonds are considered a key component in most well-diversified portfolios, irrespective of changes in interest rates:
- Bonds act as a “shock absorber” and a counter-weight to an otherwise equity-centric portfolio. Bonds are far less volatile than stocks, and thus reduce the overall risk in a portfolio.
- In addition to their lower absolute volatility, bonds are also not highly correlated with stock returns, and often move in precisely the opposite direction of stocks, particularly during large stock market draw-downs, making them excellent agents of diversification.
- Bonds can provide a more stable and predictable source of income than stock dividends, as well as a known maturity date and final redemption value.
As for how bonds may be expected to perform in a rising rate environment, let’s examine the returns of some benchmark Dimensional bond mutual funds in 2013, a year in which interest rates rose significantly. Over those 12 months, the yield on the US 10 year Treasury bond almost doubled from 1.76% to over 3% on December 31.
The DFA funds I’ve selected to highlight were chosen because together they cover much of the fixed income asset class, including US Treasurys, foreign government and US corporate bonds. The performance of the five Dimensional bond funds in 2013 is shown in the table below:
Dimensional Fund Advisors fund name
DFA Five-Year Global Fixed Income
DFA Investment Grade Portfolio
DFA One-Year Fixed Income Port
DFA Two-Year Fixed Income Port
DFA World Ex U.S. Government Fixed
There are some interesting conclusions one can draw from these results:
- Examining the last column, it’s clear that bonds are far less volatile than stocks. Even during a period of rapidly rising interest rates, the “riskiest” fund on the list was still only about 1/3 as volatile as a stock mutual fund over the course of a typical year.
- Two of the five funds had a positive return, even as rates were rising in 2013. Those two funds (One-Year Fixed and Two-Year Fixed) hold only high-quality, short-term instruments and were able to re-invest interest income at higher rates throughout the year. But even the worst performing fund (Investment Grade), consisting of US investment-grade corporate bonds, lost less than 3%, in what was arguably a very negative environment for fixed income investments.
- These modest losses are a reasonable price to pay for the long-term risk management that bonds provide to a portfolio, particularly when there is a downturn in the stock market.
So before you sell all your bonds, remember that despite all the dire warnings, no one can accurately forecast the future direction of interest rates. Even if rates do rise further, many bond funds can still produce modest positive returns, in particular those that contain shorter-term bonds that are less sensitive to changes in interest rates. Fixed income investments serve a useful purpose in diversified portfolios, and the reasons that bond funds were originally included as part of your portfolio likely still make sense today.