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Bonds and risk: Putting interest rate changes in perspective

August 05, 2013

Bonds have long had a reputation for stability, and they've been attractive for those looking to offset the risks that come with investing in stocks. However, recent developments have caused many investors to view the bond market as unusually risky.

Low yields, higher-than-normal volatility, and the prospect of rising interest rates as the U.S. Federal Reserve begins to taper off its aggressive efforts to stimulate the economy sometime in the near future have given rise to fears of a significant bond downturn—and, in some quarters of the financial media, talk of a "bond bubble" on the verge of (or in the process of) bursting.

Although the potential for negative short-term returns for bonds is high, over long-term periods we expect bonds to continue to reduce the risk of loss for balanced investors.

Even when interest rates rise, what ultimately matters most for loss-averse investors is the return of their total portfolio, not just the returns of their bond holdings.

Given these concerns, Vanguard's Investment Strategy Group has updated a research paper we issued in 2010 on the risk of higher interest rates to a broadly diversified bond portfolio. An overview follows here, or you can download the full paper.PDF

A somewhat gloomy outlook—but there's a silver lining

Based on our analysis, Vanguard believes there's a strong probability that over the next 10 years the return of broadly diversified investment-grade bonds (those whose credit quality is considered to be among the highest by independent bond-rating agencies) will underperform their average of the last 10 (+4.66% through May 31, 2013, based on the Barclays U.S. Aggregate Bond Index), and there is a higher-than-normal possibility of bonds realizing a negative return in the short term.

That said, we believe that a bear market in bonds is unlikely to be as severe as a bear market in stocks in terms of the potential downside loss.

For stocks, the common definition of a bear market is a decline of at least 20% in prices. To most investors, in contrast, a bear market for bonds is simply a period of negative returns. And to date (as of May 31, 2013), the broad U.S. bond market has never experienced a –20% return. Indeed, it's the magnitude of returns that is the key differentiator between bad periods for bonds versus stocks.

For example, the worst 12-month period for U.S. bonds since 1926 (the 12 months ended September 1974) saw a decline of –13.9%, while the worst 12-month period for U.S. stocks (the 12 months ended June 1932) returned –67.6%. In another example, the worst calendar year for the broad bond market since the inception of the Barclays U.S. Aggregate Bond Index was 1994, in which, owing to an unexpected upward shift in interest rates, the bond market dropped –2.9% (in 1995, following the decline, the bond market surged +18.5%). Contrast this full-year decline with the experience of stock investors in 2008, in which the Standard & Poor's 500 Index lost more than –2.9% over the course of 27 individual trading days.

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Another point to consider: If a bond bear market were to occur, Vanguard believes investors would be able to somewhat offset price declines with higher nominal yields (that is, unadjusted for inflation) and potentially higher subsequent nominal returns.

Math drives bond returns

Bonds are uniquely affected by movements in interest rates. Rising rates lead to higher yields and lower prices (that is, capital losses) and vice versa. The sensitivity of a bond's price to changes in interest rates is measured by duration, the common metric for evaluating risk between two comparable fixed income investments.

A rule of thumb is often used to generalize the relationship between interest rate movements and bond performance: If interest rates increase 1%, a bond's value will drop by approximately the bond's duration. (For a bond mutual fund, the value would drop by the fund's weighted average duration.)

As of May 31, 2013, the yield on the Barclays U.S. Aggregate Bond Index stood at 2.1%, with a weighted average duration of 5.5 years.

To use a simple example, a 1% rise in yields during a 12-month period would lead to a new yield of 3.1% and a capital loss of –5.5%. All else being equal, the expected total return during that period would be the average of the starting and ending yields: 2.6% plus the capital loss associated with the rising yields (–5.5%), or –2.9%. Following the 1-percentage-point rise in rates, the initial expected return for year two would be 3.1%, instead of 2.1%. Over a two-year holding period, an investor would roughly break even in this example.

Despite today's lower outlook, not all bonds are alike

The current low level of interest rates can't predict their future course, but it does tell us that the possibility of realizing a loss in higher-quality bonds in the short term has rarely been higher. Today's low yields mean that even a small increase in interest rates may result in price declines that exceed the income that bonds generate.

That said, it's important to recognize that not all bonds are alike in terms of their sensitivity to interest rate changes. Some of the more dire pronouncements regarding losses in bonds reflect the experience an investor might realize in more interest-rate-sensitive bonds with very long durations.

The chart below illustrates the hypothetical impact of a one-time 3% increase in interest rates on a $100 investment in a long-term bond portfolio versus a broadly diversified total U.S. bond portfolio. (An interest rate jump of this magnitude has happened only twice—in the early 1980s, as the Federal Reserve sought to combat inflation.) For both hypothetical portfolios, the interest rate hike results in a loss in year one, with the largest losses realized in the long-term portfolio, which is more sensitive to changes in interest rates.

Bond risk chart one

Notes: This hypothetical example does not illustrate any particular investment. The broad U.S. bond market is represented by Barclays U.S. Aggregate Bond Index. Long-term U.S. bonds are represented by Barclays U.S. Long Government/Credit Bond Index. For simplicity, durations were assumed to remain at 5.5 years for the broad U.S. bond market and 14.4 years for long-term bonds, per the durations for each benchmark as of May 31, 2013. In practice, as yields change, duration also changes. Such a dramatic change in yields as this example assumes would likely constitute a rather significant adjustment to a fund’s weighted average duration. For purposes of illustration, we assumed no changes to yields in subsequent years. Source: Vanguard.

As shown, the losses in the long-term bond portfolio in year one are sizable, conform to the common definition of a bear market in equities, and would require eight years to recover. Meanwhile the broadly diversified bond portfolio, which is more similar to the bond exposure of the "average" investor, realizes a −12.9% loss in year one and recovers all losses by the end of year four.

This analysis isn't meant to dismiss a loss of this magnitude as insignificant or to rule out the possibility of an even larger loss. Indeed, a –12.9% loss would exceed that of any 12-month decline that a diversified U.S. bond investor has realized since September 1974. This example is designed, rather, to illustrate how over time, a diversified long-term investor can recover losses realized during a sharp spike in interest rates, and that the losses realized during this period are likely to be smaller in magnitude than that of a typical bear market in equities.

More to consider than just interest rates

In recent weeks, bond investors' attention has been focused almost exclusively on interest rate risk. A more complete view of risk recognizes that bond prices are influenced by many other factors, including unexpected changes in inflation expectations, credit fundamentals, market liquidity, and government risk developments, among others.

The bottom line: If you're making portfolio decisions based solely on an interest rate forecast, you may expose yourself to unintended outcomes and higher levels of volatility.

The chart below compares the performance of a variety of bonds with that of stocks during the 2007–2009 global financial crisis (blue bars) and the subsequent stock market recovery (gold).

Bond risk chart two

Notes: Returns for U.S. stocks and international stocks represent price returns; returns for bonds represent total returns. U.S. stocks represented by MSCI US Broad Market Index; international stocks represented by MSCI World Index ex USA; emerging-market bonds represented by JPMorgan Global Emerging Markets Index; high-yield bonds represented by Barclays U.S. High Yield Bond Index; corporate bonds represented by Barclays U.S. Corporate Investment Grade Bond Index; U.S. bonds represented by Barclays U.S. Aggregate Bond Index; and Treasury bonds represented by Barclays U.S. Treasury Bond Index. Source: Vanguard.

As you can see, some of the more popular substitutes for U.S. Treasuries—emerging-market debt, high-yield bonds, and even corporate bonds—periodically exhibit return patterns that are far more similar to those of equities than bonds. Although long-term U.S. Treasuries have much higher volatility and price sensitivity to changes in interest rates, they have historically helped to mitigate equity market volatility in a "flight to quality.

Even in a downturn, an important role for bonds to play

Although our analysts conclude that the risk of losses for bonds has increased and that future returns could be significantly reduced, we continue to encourage investors to view bonds as a diversifier, helping offset riskier assets like stocks. Ultimately, most investors should consider maintaining a strategic allocation to bonds and avoid tactical changes that may increase their risk exposure.

Experience convinces us that diversified bond exposure remains a prudent complement to stocks. Such a strategy may help protect against losses similar either to the historical declines of longer-duration bond portfolios when interest rates have risen, or to the level of decreases similar to those experienced by lower-quality bond portfolios when equity markets have declined.

And although the potential for negative returns in the short term for high-quality bonds has never been higher, over long-term holding periods we expect bonds to continue to reduce the risk of loss for balanced investors. Even when interest rates rise, what ultimately matters most for loss-averse investors is the return of their total portfolio, not just the returns of their bond holdings.

 

Notes:

The projections or other information generated by the Vanguard Capital Markets Model® regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results. VCMM results will vary with each use and over time. The VCMM projections are based on a statistical analysis of historical data. The asset-return distributions shown in this paper are drawn from 10,000 VCMM simulations based on market data and other information available as of December 30, 2012. Future returns may behave differently from the historical patterns captured in the VCMM. More important, the VCMM may be underestimating extreme negative scenarios unobserved in the historical period on which the model estimation is based.

  • All investments, including a portfolio's current and future holdings, are subject to risk, including the possible loss of the money you invest.
  • Past performance is no guarantee of future returns.
  • 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. High-yield bonds generally have medium- and lower-range credit-quality ratings and are therefore subject to a higher level of credit risk than bonds with higher credit-quality ratings. 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. U.S. government backing of Treasury or agency securities applies only to the underlying securities and does not prevent share-price fluctuations.
  • There are additional risks when investing outside the United States, including the possibility that returns will be hurt by a decline in the value of foreign currencies or by unfavorable developments in a particular country or region.
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