Yield surge: Remember bonds' real role

November 23, 2016

 

Yes, the rate rise has spawned many headlines. But whether rates continue to increase, no one knows.

Rather than help clients by calculating outcomes, help them by offering perspective. While the suddenness of the climb has unsettled many, higher rates are good for many reasons and should not induce panic.

For those wanting to sell out of bonds, ask if they would prefer the reality of underperforming bonds to a world in which all asset classes in their portfolios moved down at the same time and by a similar magnitude. Ask if they're also ready to sell their stock positions, which are riskier than any bond position.

Remind skittish clients that investing success is defined by the long term and can require discipline and diversification.

Below are a few talking points to help in your conversations.

Bond yield chart

Perspective on rising rates in general

  • It's the change in expectations that moves rates and bond values. Higher rates (with a modest increase in inflation) mean a healthy economy and higher-income opportunities, both of which are good for long-term investors, and have been the goals of the Federal Reserve and policymakers for some time.
  • There's no guarantee rates will continue to rise in the short term. Unexpected fiscal or monetary policy events could result in downward pressure on rates. Rates don't have to rise just because they're low, and they don't have to keep rising just because they have recently.
  • As a rule of thumb, investors with a time horizon longer than the duration of their bond holdings will be better off in the long term with a rise in rates today.

What has driven rates up this time

  • A change in political power can heighten uncertainty, which markets don't like. The bond market sell-off is an indication that investors are continuing to digest unknowns, which include projections that U.S. economic growth could see a short-term boost under President-elect Donald Trump's agenda. That said, many factors affect the prospects for growth, well beyond policy proposals.
  • Markets are also responding to increasing expectations that the Fed will raise rates in December. However, the Fed has indicated that the pace of future increases will be gradual, which is likely to translate into lower bond market volatility and a more benign environment, rather than one in which rates rise sharply. 

Role of bonds in a portfolio

  • Successful portfolio construction is not just about returns. It is also about diversification or downside protection. The primary source of risk in portfolios is stocks, not bonds.
  • While Treasuries have seen the biggest price declines in the recent surge, high-quality bonds have been great diversifiers against the larger losses of stock holdings. This has largely been the case throughout the markets' histories. But we saw it recently in August 2015, January 2016, and June 2016.
  • The total-return experience over time is likely to be less volatile if bond allocations are maintained. When bonds declined in the past, the equity portion of a balanced portfolio often more than offset the decline.
  • Diversifying bond exposure globally (and hedging the currency risk) is one option to mitigate the short-term risks of a rise in domestic interest rates without altering strategic asset allocation.

Risk of loss (bonds versus stocks)

  • The risk of loss for bonds is very different from the risk of loss for stocks in the potential magnitude. We've seen on average negative returns in bonds once every six years, versus negative returns in stocks once every four years.
  • A bad result for a diversified bond portfolio is usually better than a bad result for stocks. The stock market's worst 12-month return was a decline of 67.6% (S&P 90 Index, ended June 30, 1932). Bonds have had a much better downside profile, with the worst 12-month return a decline of 13.9% (Lehman Brothers U.S. Long Credit AA Index, ended September 30, 1974).

Impact of rising rates on portfolios

  • Shortening maturities may help protect principal in the short run but could lower income over the long run. Bond funds with longer durations may take longer to recover principal, but, historically, the recovery has not been much more than those for shorter-duration funds.
  • Duration tilts are difficult. The long-term natural level of interest rates is uncertain. Duration bets must be placed almost perfectly on the yield curve to pay off.

Notes:

  • All investing is subject to risk, including the possible loss of the money you invest.
  • Past performance is no guarantee of future returns.
  • Diversification does not ensure a profit or protect against a loss.
  • Bond funds are subject to the risk that an issuer will fail to make payments on time and that bond prices will decline because of rising interest rates or negative perceptions of an issuer's ability to make payments.
 

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