Owning bonds is primarily about receiving a predictable interest payment on a regular schedule. Bonds can also provide peace of mind in an investment portfolio because they may complement more volatile investments like equities. However, with interest rates at historical lows and investors seeing losses in their bond holdings since July, buying bonds is a fraught topic for many investors.
When someone buys a bond, they lock in current interest rates for the maturity of the bond. For example, if an investor buys $100,000 of a newly issued 10-year U.S. government note yielding 1.85 percent, they will receive interest payments of $1,850 a year. At the end of 10 years, the maturity date of the note, they will get their $100,000 back. Because the U.S. government stands behind the bond, the investor can have confidence they will receive the interest payments and get their principal back.
Many investors today are worried about buying bonds because they feel interest rates are too puny given historical levels. They are also concerned that interest rates may continue to increase, so they may delay buying longer term bonds in hopes of ‘market timing’ their purchases. Let’s explore these topics.
How puny are interest rates? Long term government bond yields have generally declined since 2000, as shown below. While interest rates have fluctuated from year to year, both nominal interest rates (the interest rate received by the investor) and real interest rates (the interest rate after accounting for the effects of inflation) have declined. For example, rates on long-term government bonds were more than 5% for much of 2006, as low as 1.9% in July of this year at the trough in interest rates, and 2.9% more recently on December 6th.
While there is ongoing debate among policy makers and financial analysts about why rates have been in secular decline, most believe it has been a combination of Federal Reserve actions to lower short-term borrowing costs and investors worldwide investing in US government securities as a safe haven. As investor demand for long-term government bonds increased, bond prices were pushed up, which meant that long-term government bond interest rates declined.
While certainly low in comparison to historical rates, interest rate levels have been rising since July, especially after the election. The long term secular decline in interest rates is widely expected to reverse in the near future because of anticipated tightening by the Federal Reserve and stimulative policies of the Trump administration. However, consensus forecasts have been wrong in the past.
What happens to the value of bonds when interest rates rise? Bond prices and interest rates are inversely related. When interest rates increase, bond prices fall. Moreover, the longer the maturity of a bond or bond fund, the larger the decline in the price. Let’s take a closer look at what has happened so far this year:
The table above shows that both bond mutual funds suffered losses in the 5-month period this year when interest rates increased. But there are differences: The long-term Treasury fund lost more than 16% over that 5-month period while the total bond market fund with its shorter average maturity lost about 5%.
Is there a difference in how individual bonds and bond mutual funds or ETFs react to interest rate changes? For investors with individual bonds already in their portfolios, bond price declines caused by rising interest rates will not impact the interest rate payments they receive. Those payments were locked in when the investor bought the bonds. However, the decline in the price of bonds will show up in their investment account statements. The decline is real, in the sense that if the investor elected to sell the bonds, they would receive less than before interest rates increased. But if they continue to hold the bonds to maturity, they will not have to realize the loss.
The situation is different for investors who own bonds through a mutual fund or ETF. Just like individual bonds, the value of the fund will decline when rates go up. However, the investor does not have the option to hold the fund until a date like a bond maturity date and receive a pre-determined amount for the investment. A bond mutual fund is always valued at current market prices for the underlying bonds, so it fluctuates in value.
Why should bonds be included in a portfolio? The answer depends on the circumstances of each investor. Other than providing income, the role of bonds in a portfolio is to act as a ‘stabilizer’ to riskier assets such as stocks and a ‘diversifier’ that has low correlation to stocks and other asset classes in a portfolio. Bonds can also provide liquidity when there are buying opportunities in the stock market. The role of bonds as a stabilizer and diversifier continues even when interest rates are low and rising.
For the past few years, many investors have restricted their bond holdings to short term bonds to protect their principal from increases in interest rates. This approach produced lower returns than longer maturity portfolios as interest rates defied expectations and continued to decline.
Now interest rates have increased with predictions of further increases in both interest rates and inflation brought about by fiscal and monetary policies. However, the expectations about government policies may already be fully 'baked' into bond prices. Also, if the forecasts are wrong, then the recent decline in bond prices will have been a good buying opportunity. Consequently, for investors with a longer time frame, it may be time to consider increasing the average maturity of bond portfolios.
DISCLAIMER: This information is not intended to provide legal or accounting advice, or to address specific situations. Please consult with your legal or tax advisor to supplement and verify what you learn here. This is presented for informational or educational purposes only and does not constitute a recommendation to buy/sell any security investment or other product, nor is this an offer or a solicitation of an offer to buy/sell any security investment or other product. Any opinion or estimate constitutes that of the writer only, and is subject to change without notice. The above may contain information obtained from sources believed to be reliable. No guarantees are made about the accuracy or completeness of information provided. Past performance is no guarantee of future results.