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Bond investing in a rising interest rate environment

August 14, 2013

In this interview, Brian Scott, a senior investment analyst in Vanguard's Investment Strategy Group, discusses concerns about the bond market and explains why Vanguard believes bonds can play a crucial diversification role in your portfolio, even in the event of a significant downturn.

We're getting a lot of questions about whether bonds are headed for a bear market. What is a bond bear market, and how is it different from a stock bear market?

It's an interesting question, because there is not a commonly accepted definition for a bear market in bonds. The answer for stocks is a rather simple one. There is a widely accepted, broadly used definition for a bear market in stocks, and that's a decline of at least 20% from peak to trough in stocks.

Brian ScottNow, if you tried to use that definition and apply it to bonds, we've never had a bear market in bonds. In fact, the worst 12-month return we've ever realized in the bond market was back in September of 1974, when bonds declined 13.9%. So we've never had a decline of the same magnitude as we've had in stocks, and I think that's one of the key differences between stocks and bonds.

Back to your original question then: What is a bear market in bonds? And, judging by investor behavior and reaction to losses in bonds, I think the answer is simply any period of time wherein you realize a negative return in bonds.

Is a bond bear market something we should be concerned about? If so, is there anything investors can do to prepare?

We've a great deal of sympathy for the anxiety that investors feel about the bond market right now. Typically, an investor that has an allocation to bonds—particularly those that have a large allocation to bonds—tend to be more risk-averse and become more unsettled when they see negative returns in any piece of their portfolio, let alone their total portfolio.

So we understand how unsettling this environment can be—and, in fact, we have actually realized a negative return in bonds. If you're looking at the 12-month return through the end of June 2013, bonds are now down about 0.7%—and when I say bonds, I'm referring to the Barclays U.S. Aggregate [Bond] Index. So, by that definition, and if you use the definition of a bear market I applied earlier, you could say—and some people have argued—that we are actually in a bear market in bonds.

And so it's unsettling; but, in times like these, what we encourage investors and their advisors to do is to look at the total return of their portfolio. And I think they'll feel much more comfortable when you take that perspective. As an example, an investor in Vanguard's Balanced Index Fund that has a mix of 60% U.S. stocks and 40% U.S. bonds realized a rate of return of 12% through June 30, 2013. So a total return perspective is especially valuable in times like this.

You recently co-wrote a research paper in which you note that in 2010, like today, investors also believed rising interest rates would cause bond losses, but that didn't happen. Does the experience of the last three years suggest anything about what investors should do now?

I think the last three years are very instructive and really impart a lot of lessons that investors can find very valuable in times like this. So for a little bit of historical perspective, back in about April/May of 2010, the yield on a 10-year Treasury note was about 3.3%. That was a level that was probably lower than almost all investors have ever seen in their investment lifetime. And you have to go back to August of 1957 to see yields as low as they were back in May of 2010.

And I think that perspective alone caused many people to assume that interest rates had to rise. And I think an important lesson from that environment and how the market actually reacted is that the current level of interest rates tells us absolutely nothing about their future direction. Just because yields are low doesn't mean that they can't go lower or that they must go higher. But at any point, in May of 2010, if you looked at what the market was pricing in and looking at forward yield curves, the market's expectation were that yields were going to rise, and the 10-year Treasury yield was going to rise to a level slightly over 4%.

In fact, what actually happened is that yields fell to just over 1.4%—again, I'm referring to the 10-year Treasury note. And if you had shortened the duration of your portfolio or moved your bond portfolio entirely into cash, you lost a tremendous amount of income.

I think another important lesson is that making knee-jerk reactions in your portfolio can be damaging over time and potentially even incur tax losses as well as higher transaction costs.

Do you have any thoughts about how to make the case that the smartest course of action is probably no action, assuming a portfolio is already well constructed?

That's a hard thing to do, because in the face of what you think is an impending loss in your portfolio, it's a very natural and even human reaction to feel like you have to do something. But we would argue, very strongly, that investors are best served by not changing their asset allocation unless some strategic element of their asset allocation has changed.

And, by that, I mean if your investment time horizon has changed, your investment objective has changed, if you really have an enduring change in your risk tolerance, then perhaps it's worth altering your strategic asset allocation. However, if those circumstances have not changed, you're probably best served by maintaining the strategic asset allocation that you set.

What are some indicators that your risk tolerance may be changing?

If you have extreme anxiety—let's face it, if you can't sleep at night, perhaps it's worth asking yourself whether your risk tolerance has changed. What we found—and we're not unique in this—is that investors tend to have a high level of risk tolerance when times are good and then when capital markets are delivering strong, positive returns. That changes sometimes over time. Now, we're not suggesting that you should frequently change your portfolio, but if you're really having a high level of anxiety over losses, perhaps it's worth becoming more conservative.

I think another way to react to the current environment is just to recognize the role that each asset class has in your portfolio. Stocks are designed to deliver strong capital gains—ideally, over the long term, above the rate of inflation so that you can grow your spending power over time. The role of bonds—at least the primary role of bonds, in our minds—is to act as a cushion or balance to stocks. Stocks tend to be much more volatile, much more prone to significant losses in bear markets in excess of 20%, and, when that happens, bonds tend to be an ideal cushion against equity market volatility.

It's very paradoxical. But perhaps, if you are feeling a higher level of anxiety because of the volatility in the fixed income markets in particular, the right answer for you might actually be a higher allocation to bonds. Because we actually think that because bonds are a good cushion to equity market volatility, over the long term, a higher allocation to bonds will reduce the total downside risk in your portfolio.

Investing can provoke strong emotions. In the face of market turmoil, some investors find themselves making impulsive decisions or, conversely, becoming paralyzed, unable to implement an investment strategy or to rebalance a portfolio as needed.

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Well, that's certainly counterintuitive. Despite what you just said, your paper does ask the question of whether investors should consider moving away from bonds.

Yeah, that's the most common question we're getting right now. There's a lot of interest in other instruments that we're calling bond substitutes. Now, there's not necessarily anything wrong with them. So I think the term might impose kind of a negative connotation on some of these bond substitutes, but people are viewing other higher-yielding investments as a potential substitute for the high-quality bonds in your portfolio.

Some of those substitutes that I'm referring to are things like dividend-paying stocks, some high-yield bonds, floating-rate bonds, etc. And one of the things that we're really encouraging investors to recognize is that, while these instruments have higher yields than high-quality bonds like you get with the Barclays U.S. Aggregate [Bond] Index or certainly with Treasury bonds, they do have a very different risk profile, particularly when equities are declining. When equities are doing very poorly, many of these bond substitutes actually act a lot more like equities than bonds.

So it sounds like attempts to reach for income could end up depressing your overall returns. Is that right?

Over the long term, we think the answer is absolutely yes, and we've done some work around this, and we've modeled what we think will be forward-looking returns of portfolios over the long term for balanced investors. And what we found is the higher your allocation is to equities, the larger the downside risk in your portfolio is over time. And that's also true if you move away from high-quality bonds and Treasury bonds, in particular, and invest your bond allocation in some of these bond substitutes we've been talking about.

Older investors may be worried about generating income in a low interest rate environment. Do you have any advice?

This may be the hardest question you've asked of all, because we have a tremendous amount of sympathy for investors in this situation, those who are older—or, really, frankly, anyone who's really dependent on their portfolio to produce income for them, to meet their current spending needs, because you're absolutely right. The traditional answers to providing income—high-quality bonds—are not providing the level of income that investors have grown accustomed to. We've actually referred to these investors—and, really, maybe more appropriately call them savers—as a sacrificial lamb of current monetary policy. The very low interest rate environment we're faced with has really imposed a severe penalty on these savers.

And our answer is that if you choose to move away from the high-quality bonds into instruments that will generate more income in your portfolio, you'll likely get more income over time, but you'll also very likely experience a much higher level of volatility in that income stream. Of course, the only other alternative is to reduce your spending, which perhaps is even harder to do than to stomach lower levels of income for your portfolio. So there really is no easy answer.

Vanguard really emphasizes the idea of total return. Could you talk a little bit more about that and what that means in light of what's happening in the bond market?

I think it goes back to not looking at each piece of your portfolio and the returns that they're currently generating, but the return of your total portfolio overall. It's very rare that all assets in your portfolio are delivering very strong returns at any point in time. In fact, you don't want that if you're a balanced investor, because if you do have assets that are that highly correlated in good times, chances are they'll be very highly correlated in bad times as well, and you'll realize very sharp losses in declining equity markets. But ideally, if you have a balanced, diversified approach to investing, you'll realize healthy rates of total return over time.



  • All investments are subject to risk, including possible loss of the money you may invest.
  • Past performance is not a guarantee of future results.
  • The performance of an index is not an exact representation of any particular investment as you cannot invest directly in an index.
  • In a diversified portfolio, gains from some investments may help offset losses from others. However, diversification does not ensure a profit or protect against a loss.
  • Bond funds are subject to interest rate risk, which is the chance bond prices overall will decline because of rising interest rates, and credit risk, which is the chance a bond issuer will fail to pay interest and principal in a timely manner or that negative perceptions of the issuer's ability to make such payments will cause the price of that bond to decline.
  • While U.S. Treasury or government agency securities provide substantial protection against credit risk, they do not protect investors against price changes due to changing interest rates. While the market values of government securities are not guaranteed and may fluctuate, these securities are guaranteed as to the timely payment of principal and interest.
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