The expensive misconception about bond safety
Rising interest rates could lead to a decline in values
Michael MaehlMarch 12th, 2015
For more than a generation, when considering what to do with their investments, one of the primary beliefs of investors has been that bonds are safe, that the risk of losing your investment in owning them—whether individually or within fund portfolios of whatever bond type—is minimal, at the worst. That can be an expensive misconception.
Few investors, talking heads, or other analysts have ever experienced a bear market in bonds. I have. It lasted about the first twelve years of my career. Investors were confused and worried as they saw their bond values dropping.
Similar to the parable about the boy who cried wolf a few too many times without result, and perhaps due to that negative early exposure, I’ve been concerned about the psychological and monetary effect that could result from a bond market turn for a couple years now, with nothing really bad having yet happened.
Nonetheless, forewarned is forearmed, I’m told. In that regard, let me provide you some facts on what can happen when rates do rise and a couple insights about how you can anticipate the effects on your holdings.
The 10-year Treasury note return, the basis for most loans, was at 6.67 percent when I started in April 1973. By October 1979, the rate had moved up to 10.3 percent. Inflation was rising fairly quickly and interest rates rose with it.
In the early 1980s, Paul Volcker, the then-chair of the Federal Reserve Board, was determined to break the proverbial back of that double-digit inflation we had been living in for some time. He did so by cranking the interest rates waaaay high. That action drove the 10-year Treasury note to its all-time high of 15.8 percent in September 1981. You could say that this was the start of the bond bull’s run. It wasn’t until mid-1985 that the 10-year rate was less than 10 percent, but the action worked and inflation dropped.
And then, about 30 years on, in July 2012, that 10-year note made a historic low at 1.4 percent. As this is written, it sits at about 2 percent. Quite a big swing, to be sure.
With the U.S. economy continuing to strengthen and growth improving, the Fed is now talking about when rates will be raised. Not if, but when. Further, in the release of their notes from the January Open Market Committee meeting, those minutes included concerns about the increased risk of “liquidity pressures” in the bond market, something that would be affected by rising rates “if investor appetite for such assets wanes.”
What the Fed is basically saying here about liquidity pressures, the desire to move out of bonds and/or bond funds and move into cash, is that there could be a problem for bond investors if or when they want to get out of these funds at about the same time. The result would be significant drops in price from the large increase in bonds for sale, combined with the outside pressure of rising rates.
Why would there be price pressure from rising rates? Regardless of who issues them or credit rating, all bonds and most securities that trade like bonds—preferred stock, utility companies, etc.—have this trait in common. Interest rates and asset prices move in the opposite direction. Therefore, an increase in rates would produce a decline in the price of a bond, unlike the past 30-plus years where the opposite result prevailed with that drop from over 15 percent all the way down to 2 percent. This is particularly significant in today’s ultra-low rate world. Here’s what I mean.
When they’re first issued, and then priced over their lives, all bonds in the U.S.—and in most developed countries—base their stated rate and subsequent price upon their respective federal government issues. As of Feb. 20, here were some examples of global market rates for notes due in 10 years. Ours was 2.12 percent. The UK was paying 1.76 percent. Italy was at 1.61 percent and Spain at 1.51 percent ... and these were at the high end. France was paying 0.62 percent. Germany and Japan were each at 0.39 percent and Switzerland, not a misprint, was “paying” 0.05 percent. Understand that these rates are locked in for 10 years. Great for borrowers; definitely not so good for savers or investors.
Recalling that interest rates and asset prices tend to move in opposite directions, all fixed income investors have had a wind at their bond investing backs since September 1981. So, they’ve pretty much seen their fixed-income assets either rise or hold their value for all that time.
The leverage will now be in the opposite direction.
What are bond investors to do?
It’s my conviction that with global rates at these historic low levels and with our economy moving well into self-sustaining mode, interest rates will be rising. While the timing is uncertain, the speed and magnitude of each rate move will directly affect the prices.
Speaking to the Fed’s concerns about liquidity, the first thing to realize is that when you own a bond mutual fund, of whatever type, you don’t actually own a bond; you own shares of the fund.
Bond funds rightfully only keep so much cash on hand. So, if investors in a fund all want to redeem their shares at the same time, it could pose problems for the fund manager in trying to meet those requests. Most likely, the manager would be forced to sell bond holdings, potentially at a discount, as the fund needed to raise cash to meet redemptions. Multiply this over the many, many bond funds out there and you get an idea of why the Fed is concerned.
Prior to having to act under duress, you can evaluate your current holdings now to determine your principal loss potential due to rising rates. You do that using the duration measurement.
Duration is a measure of how much the price of a fixed-income instrument can change in response to a move in interest rates – either up or down.
Other factors influencing duration include the length of time until a bond comes due, its credit rating, and its rate of return, relative to prevailing rates. A good rule of thumb is that the higher the duration of a bond or fund, the greater the sensitivity to moves in rates.
For reference, in terms of U.S. sectors, investment grade bonds, including U.S. Treasuries, currently have a duration of more than seven years. Tax-free issues are at about five years. High-yield bonds, which due mostly to having stated rates of return usually above that of other issues, come with the lowest relative duration of around four years.
I recommend you review the holdings pages of your bond funds. Somewhere on the page, you’ll almost always find the duration of that particular fund. It varies by fund—even from the same manager—so you’ll have to check each.
Bonds do need to be in any solid asset allocation strategy. I further suggest that, if you find relatively high duration numbers in your holdings, you search for other funds of similar quality to those you own, but with lower durations, and reallocate.
Michael Maehl is an independent financial adviser and Spokane-based vice president of Opus 111 Group LLC. He can be reached at 509.747.3323 or firstname.lastname@example.org.