In the last few days, bonds have experienced a sharp upward movement in yields across all maturities, but especially so in what traders call “the belly of the curve”, maturities between 2 years and 10 years. And since bond yields and bond prices move inversely to each other, as bond yields have risen, bond prices have fallen, creating a drag on the performance of portfolios that hold a diversified basket of stocks and bonds. The decline in bond prices and the resulting drag on portfolio performance prompts two questions. 1) “Is the bond bear market, which pundits have been forecasting for years, finally here?” and 2) “If bond yields continue to rise, and bond prices continue to fall, should an investor maintain an allocation to fixed income in their portfolio at all?”.
While the first question makes for good cocktail conversation, we think it’s too early to forecast with any certainty whether bonds have entered into a prolonged, multi-year bear market. Only time can answer the first question.
The second question, however, is an important one. In order to answer it, we have to look at the key risks that bond investors face when allocating a portion of their portfolio to fixed income, and we have to look at what vehicles investors use to satisfy that allocation.
First, bond investors face a number of risks, most of which are peculiar to the specific bond they are considering purchasing, and therefore, can be eliminated simply by avoiding particular types of bonds (high yield bonds, for example carry greater default risk, whereas U.S. Treasuries carry virtually no default risk). For the purposes of our discussion, there are only two risks we need to consider: interest rate risk, whereby bond prices fall when interest rates rise, and reinvestment risk, whereby bond payments received (interest and maturity) are reinvested at lower interest rates.
Since bond prices fall when interest rates rise, allocating a portion of a portfolio to fixed income necessarily incorporates interest rate risk, BUT ONLY WHEN CERTAIN TYPES OF FIXED INCOME VEHICLES ARE USED. As we discuss in a moment, investors can effectively mitigate the interest rate risk by avoiding certain types of fixed income investments.
Reinvestment risk, on the other hand, is a bond investor’s friend when interest rates are rising. When a fixed income investor receives interest payments, and especially when a bond matures, those cash flows can be invested at higher interest rates at that moment in time, which increases the investors’ overall rate of return, all else equal. So in a rising interest rate environment, reinvestment risk IS ACTUALLY BENEFICIAL to fixed income investors, and therefore, argues in favor of an allocation to fixed income when interest rates are rising.
But not all fixed income vehicles are created equal. In fact, there is a wide disparity between the effectiveness and therefore usefulness of various fixed income vehicles. On one end of the spectrum are individual bonds, which, when used properly, are effective at mitigating interest rate risk, leaving only the positive impact of reinvestment risk. On the other end of the spectrum are bond funds, whether they be exchange traded funds, actively managed mutual funds, or passively managed index funds. In truth, these funds have more in common with stocks than they do with bonds.
Let’s start with individual bonds. An individual bond’s ability to mitigate interest rate risk is solely the result of its nature as a contract, which specifies a defined maturity date and maturity price. Excluding the possibility of default (breach of contract), an investor can be assured of their rate of return when they purchase the bond, because they know exactly what price they paid for the bond, what their cash receipts will be, and when they will receive them. This assurance is what gives bonds their “anchor to windward” characteristics, and why they are considered to be, in general, a risk-averse, defensive, less volatile asset class than stocks. Granted, between the time an investor purchases a bond and the time it matures, the price of the bond will fall if interest rates rise, but the bond’s price decline IS ONLY TEMPORARY. Once the maturity date of the bond draws closer, the bond price will approach the maturity price, such that upon maturity, the investor will receive exactly what they expected to receive. In this way, an investor can ignore the negative impact of rising interest rates on an individual bond, with the confidence that the price will recover, and that ultimately they will earn the rate of return they expected when they purchased the bond.
On the other end of the spectrum are bond funds, which are fully exposed to interest rate risk. Unlike individual bonds, bond funds lack the contractual mechanism (stated maturity date and maturity price) that offsets interest rate risk. There is no mechanism that returns a bond fund’s price to a pre-determined level at a pre-determined time. Moreover, the absence of a stated maturity date and maturity price robs an investor of the certainty and confidence that an individual bond would otherwise provide. Because a bond fund investor does not, and cannot, know the price at which they will sell the fund, their ultimate rate of return when buying a bond fund is not only unknown but unknowable. For this reason, a bond fund is more akin to a stock, which has the exact same characteristics, than an individual bond.
In most cases, the interest rate risk is larger than the potential gain an investor would receive from reinvestment risk when interest rates are rising. Therefore, it’s entirely feasible for a bond fund investor to LOSE money during a rising interest rate environment, while an investor using individual bonds would MAKE money during a rising interest rate environment, AND be in a more attractive position since they can now reinvest their cash receipts at even higher interest rates.
As with all things, there are a few caveats. First, an investor who buys an individual bond and sells it prior to maturity would take on interest rate risk, in exactly the same way a bond fund investor does. Offsetting interest rate risk requires an investor to hold the bond to maturity. Second, there are bond funds that have stated maturities, and while they have stated maturity dates (roughly, within a few days), they do not have a stated maturity price, and therefore, the ultimate rate of return is still uncertain, just like it is for a bond fund.
So, back to our question – “If bond yields continue to rise, and bond prices continue to fall, should an investor maintain an allocation to fixed income in their portfolio at all?” The answer is “Yes, as long as they use individual bonds for their fixed income allocation.” In fact, we’d even go one step further; an allocation to Fixed Income using individual bonds is especially important when interest rates are rising because rising interest rates often mark the final phase of an economic expansion, before economic activity declines and stock prices decline with it. But we’ll save that topic for our next entry.
In the meantime, if you have questions or comments about this piece, or own bond funds and have already experienced losses in them, or concerned you will in the future, shoot us a note. You can use the “Contact us” form at the bottom of this page, or simply email us directly.
