When I published my most recent piece at Seeking Alpha (“Is It Really 10 Times Riskier To Retire Now Than A Decade Ago?”), one of the first commenters chimed in with a simple but direct statement: “I can never understand why one would invest in bonds.”
Setting aside the more global question about fixed income’s role in an overall portfolio strategy (the answer usually has to do with the role of asset class diversification in generating superior risk-adjusted returns over time), a more specific version of the question has become increasingly common in recent months: “Why would you invest in bonds now, in our newfound rising rate environment?” It’s certainly a fair question, particularly in light of the fairly rapid increase in Treasury rates in the weeks following last November’s presidential election.
And yet, it’s not necessarily a simple or easy question to answer. Even if rates do indeed continue to rise, a number of factors that we can’t currently know will have a significant impact on the proper portfolio response. How high will rates go? How long will it take them to get there? Will long-term rates increase more or less than short-term rates? What about the spreads between corporate bonds and government bonds—will they be compressing or expanding? How about high-yield bonds, or “bond surrogates” like preferred stocks, utility stocks, and REITs? Finally, will the increase in rates have any impact on debt issuers’ ability to refinance their debt, or, ultimately, their ability to repay it? Could a rising rate environment in fact spur an increase in the rate of bond defaults?
Simply put, the convexities and intricacies of bond math are such that even the term “rising rate environment” is insufficient to describe or predict the actual behavior of your portfolio. Some rates may rise, but others might stay the same, or in fact fall. It all depends on what rates we’re talking about, what sorts of instruments we do (or don’t) own, and how the various types of investments interact with each other.
While recognizing, then, that there is no magic bullet that can help solve all our fixed income portfolio issues for us, I think it’s instructive to take a data-driven look at what might happen, based largely on what has happened in the past. In the process, I’ll focus on contextualizing the issue and getting down to one basic question—is now a good time to change your overall investment approach, or not?
Don’t outsmart yourself
It’s been interesting for me to hear so much chatter about a “rising rate environment,” considering that very few people who are currently working on Wall Street have ever actually seen one (according to this Bloomberg chart, nearly a third of Wall Street traders have never worked in a market with a non-zero short-term interest rate; essentially none have traded in a true “rising rate” world, which we last saw back in the days of disco and rotary phones).
While there have been periods of rising interest rates along the way, those periods have typically been very short-lived, lasting barely a year before succumbing to the broader trend. That’s hardly anything to get worked up about, and it certainly shouldn’t be an impetus for a wholesale reconsideration of your investment portfolio.
With that history as the backdrop, can we even be confident that we would properly diagnose a bona fide rising rate environment if we saw one? Or, like so many stock market bubbles, would we only be able to identify one in hindsight?
Much of the analysis on the topic seems to center around the concept that it’s “just a matter of time” before rates turn higher, because they “can’t go lower” once we’ve reached the zero-bound. While it may be technically true that rates can’t go too far below zero (at least not in nominal terms; real interest rates can often be a different story), that certainly doesn’t mean that they automatically have to turn in the opposite direction.
Consider the experience of Japan, which has known near-zero interest rates for nearly a generation:
The benchmark rate in Japan first sliced below 2% in 1995 (around the time of the O.J. Simpson trial), and it’s remained there for more than 20 years. Not only is that not likely to change any time soon, but if anything, Japanese authorities are also becoming even more aggressive with their financial repression tactics—last year, rates on Japanese bonds all the way out to 20-year maturities were boasting negative nominal yields.
Of course, ask any economist you like and they’ll probably be happy to tell you that we’re not Japan (neither is Sweden), which is very insightful—if not particularly helpful—information. Sure, the underlying fundamentals and demographics of the economies vary widely, but in our increasingly financialized (and globalized) world economy, those differences are seemingly less prominent and meaningful by the year. International capital flows are a big part of the game, and it’s naive to pretend that the United States is somehow immune to the ills that have at times plagued other global economies.
That point aside, predictions of a “rising rate environment” are certainly nothing new—on the contrary, market participants have been predicting a “liftoff” in interest rates for several years now, to no avail.
When the Fed finally did begin incrementally increasing the Fed Funds Rate in December of 2015, the move was about five years later than most pundits had predicted. Those predictions had, of course, been wrong not just for the short-term rate, but for longer-term interest rates as well. In short, the hand-wringing about rising interest rates has seemingly become our national default setting, and if you’d taken action to immunize your portfolio five years ago, you’d still be waiting for your satisfaction. Is there any compelling reason to believe that this time is any different?
A continued period of rising rates is far from a “sure thing,” as history has consistently demonstrated. Remaining nimble and flexible remains, as usual, the name of the game.
But what if rates really do keep rising?
Fine, fair question. Wrong as we all may have been for the better part of the last decade, the Fed does seem committed to its rate-hiking cycle, even if recent meetings have generated more cautious commentary. So, what would such an action mean for the markets more broadly? History might give us some clues.
Even amid the 30-year bond bull market, there have been four previous instances in which the Fed has raised short-term rates (1988, 1994, 1999, and 2004), and studying how markets reacted to those periods could tell us something about how we should approach the next several weeks or months.
Again, don’t confuse an increase in the Fed Funds rate with an increase in broader “interest rates,” particularly those with a longer duration (which includes most investment-grade securities; only bank accounts and short-term CDs are realistically focused on Fed Funds as their guiding rate). In fact, there’s some evidence that an increase in the short-term rate could put downward pressure on longer-term rates, perhaps owing to a “sell the news” response on the part of traders and investors.
Regardless of the reasons behind that last finding, if you’ve waited until the Fed has actually started raising rates to make any moves, it’s possible that you’re already too late. But that aside, let’s take a dive into the data.
What happens to bond prices?
Basic bond math dictates that rising interest rates mean falling bond prices. So, if you hold fixed income securities in your portfolio, what can you expect when rates rise? Let’s take a look at the data, focusing on the longest-term bond rates (30-year rates), which are the most sensitive to changes in interest rates (they’re also the basis for most home mortgage rates).
The last four Fed rate-hiking cycles lasted an average of 14.5 months (note that this current “cycle” has already lasted 14 months, if we count from the first quarter-point hike), with an average increase in the Fed Funds rate of just more than 3%. The increase that flowed through to long-term rates was far from one-for-one, as longer-term rates increased by an average of roughly 1%.
Still, small increases in rates can have an outsized impact on the pricing of longer-term fixed income securities, as the “Capital % Gain/Loss” column displays—that small rise in rates meant an average decline of slightly more than 10% in bond prices. Of course, since fixed income securities pay periodic interest, those interest payments did compensate somewhat for that capital loss (in two of the four instances, the total return for holding bonds during the periods of Fed rate hikes was actually positive despite the increase in rates).
On average, the total return for 30-year bonds during the most recent four periods of rising interest rates has been -1.3%, a modest loss given the perceived risk. Recognizing that average returns for fixed income securities over that time period have hovered around 5-6%, that’s an underperformance of 6% or 7%, depending on how you want to measure it. Not good, but also far from catastrophic.
It does bear mentioning that the fact that overall interest rates are lower now than they have been in the past means less “cushion” from interest payments for the investor in longer-term bonds—indeed, if the 30-year rate were to rise by 1% over 12 months in the current environment, the total return on a 30-year bond investment is estimated at about a -12% return, which is far worse than the average of the last four rate hike cycles. Caveat investor.
What happens to stock prices?
In theory, changes in interest rates should have only indirect effects on stock prices—higher borrowing costs can hamper certain types of businesses while they can be a boon for others. What is typically more important with respect to the stock market is what the interest rate trend says about the broader economy (if a rising rate means the economy is growing, that should be good for companies and their stocks).
Financial theory aside, let’s look again at the data:
As with the bond data, the results are a little all over the place, but the trend is clear, with positive average returns over every relevant time frame.
However, it does bear noting that the average annual return for the S&P 500 since 1985 is a shade below 13%—therefore, an average one-year return of 6.5% for stock prices represents an “underperformance” of between 6% and 7%. If you’ll recall, that’s coincidentally the exact same rate of underperformance that we found in the 30-year bond study up above. So, both stocks and bonds have done worse than average in the periods immediately following Fed rate hikes, but stocks are better in absolute terms because their average returns are higher.
Ultimately, the long-term trend in stock prices is rarely disturbed by a short-term change in the direction of rates, though short-term returns are depressed somewhat. The same has generally been true of bonds. There have been short-term disruptions, but the overall trend has been for higher bond prices, and positive total returns.
What’s the take-home lesson?
When it comes to interest rates (and predictions thereof), there’s rarely any great reason to deviate significantly from your longer-term investment plan. Unless you know for certain what the future direction of rates will be (and nobody does, not even the “data-dependent” Fed), your best bet is to stick to your overall plan and let the market’s actual price action determine your next steps, lest you cost yourself dearly via an interest rate bet gone bad.
Yes, it might be a decent idea to shorten the duration of your bond holdings, but it’s important to recognize that doing so comes with an opportunity cost of decreased interest payments in the meantime, which you won’t be able to recoup if you’re wrong about the direction of rates. There’s no such thing as a free lunch in the investing world, just a series of risk trade-offs.
The evidence for the benefits of a diversified portfolio with periodic rebalancing is well developed and well reasoned—ongoing media hysteria should not distract investors from those basic points, and may in fact be counter-productive. Treat volatility as an opportunity and not a risk, and you may end up just as well off as if you’d had an actual crystal ball. And if you do have a crystal ball, please call Janet Yellen; I think she might need it.