Since the onset of the Great Recession, the Fed has driven interest rates to near zero, facilitating one of the biggest bond bull markets in history. Now, many investors believe that a rate increase is just around the corner. After all, despite media quips about “QE Infinity” it is simply not feasible for the Fed to continue buying its own intermediate-and-long-term bonds forever.
At a recent conference, Atlanta Fed President Dennis Lockhart said that he expects the U.S. central bank to begin raising rates in mid-2015 while an October 2013 survey of 50 top economists by the Wall Street Journal forecast a near one percent rise in rates by the end of 2014. Of course it’s important to remember that an early 2010 Wall Street Journal survey of economists predicted a 4.24% 10-year Treasury yield by year end. Ultimately rates actually declined, finishing the year at 3.30%. It should therefore come as no surprise that a 2005 study by professors at the University of North Carolina finds economists’ predictions of interest rates to be less accurate than a coin flip.
A Stopped Clock is Right Twice Every 24 Hours
But what if economists are finally right and the Fed does allow interest rates to rise? What in particular does this mean for bond investors? Bonds are unique compared with other investments in that a given return stream is well defined due to a highly certain income stream. As a result, bonds are uniquely affected by movements in interest rates. Rising rates lead to higher yields and lower prices (i.e., capital losses) and vice versa.
The sensitivity of a bond’s price to changes in interest rates is measured by duration. Duration is a common metric for evaluating interest rate risk in bond investments and the rule of thumb is that if interest rates increase 1 percentage point, a bond’s value will drop by approximately the bond’s duration. Of course there are other factors that will impact a bond’s price but for the sake of this discussion we will use duration as the primary factor.
Impact of Rising Rates on Bonds
At the time of this article, the yield on the Barclay’s Capital U.S. Aggregate Bond Index stood at 2.3% with duration of 5.7 years. In the most simplistic of examples, a 1 percentage point rise in yield during a 12-month period would lead to a new yield of 3.3% and a capital loss of -5.7%. The expected total return during that period would be the average of the starting and ending yields, 2.8% plus the capital loss associated with the rising yields, -5.7 or -2.9%. The good news is that following the 1 percentage point rise in rates, the initial expected return for year 2 is 3.3%, instead of 2.3%.
But what happens if interest rates unexpectedly rise by a significant amount, say 4 percentage points? Such a move has happened only twice in the United States, once in 1980 and again in 1981, as the Federal Reserve drove interest rates higher in an effort to combat high inflation. But in relative terms, a rate jump from 2.3% to 6.3% would constitute a 170% change in rates – a change that has never occurred in the United States. At -22.8% (4 x 5.7), the price decline in year 1 would represent the worst year ever for U.S. bond investors (the actual worst 12-month return for the Barclay’s Capital U.S. Aggregate Bond Index was -9.2% during the 12 months ended March 31, 1980). However, the new yield starting in year 2 is of greater importance as our diversified investor would now expect a 6.3% return going forward. Three years following the hypothetically worst bond market ever, the diversified bond investor would be back in the black simply by reinvesting interest distributions.
Putting a Bond Bear Market in Context
When evaluating the potential risks in the bond market, it is critical to remember why bonds are part of a well-thought-out asset allocation plan – to diversify the risk inherent in the stock market. Simply put, a potential bear market in bonds is dramatically different from a bear market in stocks. While the common definition of a bear market in stocks is a 20% decline in prices, the broad U.S. bond market has never experienced a -20% return. In addition, it is important to bear in mind that while rising interest rates may mean a modest decline in bond prices, they also mean higher nominal returns over the long run.