The Impact of Rising Interest Rates on Bonds

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A rise in interest rates has been widely anticipated for some time. According to an October survey of 50 top economists conducted by the the Wall Street newspaper, the 10-year Treasury yield is expected to increase by almost one point to 3.47% by the end of 2014. What impact would such an increase have on your investment portfolio?

First, Christopher Philips, senior analyst within Vanguard's investment strategy group, points out the historical inaccuracy of such forecasts. For example, a similar survey conducted in 2010 had economists predicting a 10-year Treasury yield of 4.24% by the end of the year, an increase from 3.61% at the time of the forecast. In fact, rates fall to 3.30% at the end of the year. The inaccuracy of these forecasts is well documented. In fact, as Allen Roth mentioned in the December issue of Financial Planning MagazineA 2005 study from the University of North Carolina titled "Professional Forecasts of Interest Rates and Exchange Rates" revealed that economists predict future rates much less accurately than they do. a random draw.

Obviously, we can not be sure what interest rates will make in 2014, but what if economists are finally right and rates go up? To what extent would an increase in interest rates be harmful to bonds? If interest rates rise by one point next year, the intermediate bond index should lose -2.8% – far from catastrophic. Of course, this potential risk is particularly small compared to the decline in shares held (remember the loss of -36.93% suffered by the S & P 500 in 2008?).

It is also interesting to study the historical performance of bonds in times of rising interest rates. Craig Israelsen, a BYU professor, recently documented bond yields over the last two periods of rate increases. Israelsen points out that although the federal discount rate went from 5.46% to 13.42% from 1977 to 1981, the government / credit intermediate index had an annualized return of 5.63% at the end of the year. during this period. The next period of rising interest rates occurred from 2002 to 2006, when the federal discount rate increased fivefold: from 1.17% to 5.96%. During this period, the Government / Credit Interim Index achieved an annual return of 4.53%. Obviously, even in an environment of rising interest rates, bond performance has been surprisingly strong.

More importantly, investors should never forget the added value of bonds to a portfolio as an equity diversifier. Often, the performance of stocks and bonds is inversely related. For example, when the stock market suffered during the crash of the technology bubble of 2000-2002, the Barclays Long-Term Government Bond Index rose by 20.28%, 4.34% and 16.99% at during those years, respectively. More recently, when the S & P 500 lost -36.93% in 2008, the long term government bond index rose 22.69% over the course of the year. This diversification advantage can be useful when the stocks will eventually cool off from the long, hot streak they have seen since 2009.

In 2013, the aggregate bond index decreased by -1.98%. Given the occasional negative correlation of performance between stocks and bonds, is it really surprising that bonds have not produced a positive return given the incredible year of stocks (S & P 500 up more than 32%)? Moreover, being held in a diversified portfolio, the -1.98% yield produced by the bonds during the recent surge in shares is not a small price to pay for the added security that it has. they are likely to provide when the markets reverse?

In summary, it does not seem prudent to avoid bonds entirely during the periods of expected rise in interest rates. First, the rate hike forecasts are far from certain. Second, even as interest rates rise, bonds can still be much less risky than equities. Thirdly, the rise in interest rates does not necessarily mean that falling bond values ​​are a certainty – in fact, bonds performed rather well over the last two periods of rate hikes. Finally, bonds are an element of vital importance in a diversified portfolio, and possession of uncorrelated and negatively correlated assets will be critical when stocks eventually lose momentum.


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