We are starting to see signs that the Bank of England (BoE) and European Central Bank (ECB) might attempt to raise interest rates following years of accommodative monetary policy. In the US, the Federal Reserve (Fed) has been raising rates slowly since 2015 including increases of almost 1% in the last year alone.
With further interest rate rises on the cards, it’s likely headlines such as, “bonds tumble as central banks raise rates” or “bond investors flee rising rates” will be commonplace. The conventional thinking here is that, as interest rates go up, bonds go down. However, it’s not as simple as this and there are several factors to consider before dismissing bonds completely.
If it’s in the news, it’s in the price
The first, and arguably most simple point is; if you know what direction interest rates are expected to go, then surely everyone else knows too. So, considering it’s unlikely you know something that no other investor knows (a fair assumption), surely this information is already reflected in the price of securities? In summary, the market has already accounted for expectations of interest rate rises in the price of bonds.
The Taylor Money one-year interest rate forecast:
There is a 100% probability that in a year’s time, interest rates will be higher, lower or the same as they are today.
Okay, it’s not helpful but at least it’s accurate. There are hundreds of different factors that will determine the direction of interest rates going forwards, so predicting their future path is nearly impossible. When asked about the economy, Warren Buffett’s righthand man, Charlie Munger, once said “if you’re not confused, you don’t understand things very well”. To us, this suggests that, rather than investing based on false certainty and predictions, being humble and open to a range of possible scenarios generally leads to better investment decisions and therefore outcomes. In this case it’s likely interest rates could go up, but also just as likely they could stay the same, or even go down. It is important then not to take an “all or nothing” approach based on forecasts or predictions but invest in a way that considers all the possible outcomes.
Conventional wisdom is that as interest rates go up, the price of less attractive existing bonds with lower rates will fall and therefore bond investors will lose money. Whilst this is true in part, there are also other factors at play. For example, as interest rates go up, income from already issued bonds, along with proceeds from maturing bonds or those being sold, can be reinvested into higher-yielding bonds. Sellwood Consulting LLC put it simply as “rising interest rates are a double-edged sword, slicing principal value from bonds already owned, while paying higher coupons on those not yet purchased.”
To illustrate this theory in real-life, we looked at the previous five periods in which the Fed raised interest rates in the US, and how the Barclays US Aggregate Bond index (a good proxy for intermediate US bonds) performed during these.
Since 1988 the Barclays Aggregate Bond index has on average returned 6.2% every year. Looking at the last column in the table, it’s clear that during rate-hiking periods returns were not as strong but they were not a disaster, or even negative for that matter. As always, this is just a historical example and bonds could act differently going forwards, but hopefully it provides some perspective to those who are concerned with how higher interest rates might impact bonds going forward.
Why are you holding bonds anyway?!
The final point to consider is why bonds are held within a portfolio in the first place. Traditionally, bonds have performed an important role within an investment portfolio due to their more stable nature in comparison to equities.
Capital Preservation: bonds sit higher in the capital structure than equities. So, despite potential short-term capital losses, over the medium term, they have acted as a stabilising component of a portfolio. This can be summarised by the old adage that ‘a bad year in the bond market is like a bad week in the stock market!’.
Stable Income: there is a reason that bonds as an asset class are called “fixed income”. This name is derived from the fact that a bond’s income payment cannot be changed, missed, cancelled or cut. So, unlike dividend payments from equities, the income from the bond portion of your portfolio is far more secure.
Volatility: holding bonds within a portfolio has had the benefit of reducing volatility. This is due to their stable capital and income, which fluctuates far less, as well as their correlation to other asset classes. During more volatile equity markets, holding bonds can provide comfort to investors and reduce wild swings in the value of their portfolio helping them to remain in the market.
Crisis Alpha: during financial shocks, most high quality bonds are viewed as a safe haven. As a result, investors buy these assets in what is often described as a ‘flight to safety’. This helps support their value and, in some cases, can generate significant positive returns. Having a portion of a portfolio which sustains a majority of its value during financial shocks does not just serve as a behavioural benefit but can also provide the capital to buy into recently discounted equities potentially enhancing future returns.
Those who invest in bonds should welcome higher interest rates if they do come as it is simply a case of short-term pain for long-term gain. Investors also need to remind themselves that bonds play an important role in any diversified portfolio. For all the reasons above, our view is that now is not the time to be giving up on bonds.
General Disclosures: This article is based on current public information that we consider reliable, but we do not represent it is accurate or complete, and it should not be relied on as such. The information, opinions, estimates and forecasts contained herein are as of the date hereof and are subject to change without prior notification. It does not constitute a personal recommendation or take into account the particular investment objectives, financial situations, or needs of individual clients. The price and value of investments referred to in this research and the income from them may fluctuate. Past performance is not a guide to future performance, future returns are not guaranteed, and a loss of original capital may occur.