by Ben Shepherd, Investing Daily
Interest rate increases wreak havoc with bond returns. When interest rates rise, the principal values of older bonds decline as buyers flock into higher yielding new issues. But as inflation and interest rates creep upwards in the coming months, you’d be foolhardy to foresake bonds altogether. We explain why, as well as pinpoint a bond fund appropriate for this investment climate.
Let’s start with the graph below, from the Federal Reserve Bank of St. Louis, which shows the effective federal funds rate — the Fed’s benchmark interest rate — since the 1950s.
Knowing that rising interest rates are bad for bonds, it comes as little surprise that the single worst one-year period for bonds was 1980, when the federal funds rate whipsawed from 14 percent to 8.5 percent then back up to 20 percent. In that year, the aggregate return on bonds was -15.5 percent, as investors struggled to get a handle on the direction of interest rates.
The worst 20-year period for bonds, again not surprisingly, was between 1961 and 1981 as the fed funds rate gradually drifted higher from about 2 percent to 20 percent. Over that period, the aggregate return on bonds was -40.8 percent.
But bonds don’t always respond negatively to increases in the fed funds rate. Looking at the trailing one-year returns of 10-year Treasury bonds, bonds typically hold their own even when the interest rate ticks up.
In fact, in the four instances that 10-year Treasuries had a negative return in the 30 years between 1983 and 2013 (1987, 1994, 1999 and 2009), the fed funds rate was only on the rise in 1994. Over the course of that year, the federal funds rate rose from 3.25 percent to 5.5 percent, shaving more than $600 billion over the value of the US bond market.
So why did the massacre happen in 1994?
After nearly three years of economic growth and relatively tame inflation, commodity prices were beginning to rise and inflationary pressures grew. In response, the Fed tightened interest rates just slightly by 25 basis points. The move came like a lightning bolt out of the blue and the hikes just kept coming.
Much like today, in 1994 investors were accustomed to a low interest rate world. While there was the added dilemma of high gearing in the bond market in those days, the real crux of the problem was that investors were ignoring signs of a return to healthy growth in the global economy.
That scenario should sound familiar to investors today.
There’s no denying that the US recovery since the Great Recession has been anemic, but it has led the global economic rebound. The International Monetary Fund (IMF) raised its global growth forecast earlier this month by 0.1 percentage point to 3.7 percent, largely thanks to the fact that it bumped its outlook for US growth by 0.2 percentage point to 2.8 percent this year. While the picture on US jobs remains mixed, household net worth has regained the ground it lost in the recession, mostly because of improving home prices.
The IMF also boosted its outlook for Japan, the euro zone and China and only shaved its forecasts for Russia (down 1 percent) and Latin America (down 0.1 percent).
The global growth picture for 2014 looks good overall, with many equity markets somewhat overvalued.
Nonetheless, Fed Chairperson Janet Yellen has signaled repeatedly that she intends to keep interest rates at their current levels through 2015, even as the Fed tapers off its bond purchases. At the same time, the European Central Bank is unlikely to back off its own near-zero percent interest rate policy and the Bank of Japan is still actively pouring stimulus money into that country’s economy.
Thanks to those easy money policies, inflation expectations are picking up.
The graph below shows the breakeven rate, or the spread between the yield on a 10-year Treasury bond and a comparable Treasury Inflation Protected Security (TIPS). When the spread widens, investors are betting on growing inflation.
As you can see, inflation worries have been growing since December, even as the US central bank has stuck to its guns on low interest rates. Odds are, when the rate increases finally happen, investors will be stunned all over again. Looking at the futures curve on Treasury bonds, most investors aren’t betting on a rate increase over the next couple of years.
So while interest rate increases are never good for the value of fixed-income securities, bonds take the worst hit when those increases are largely unexpected. If you pair that with growing inflation expectations as occurred in the 1970s and early 1980s, the effect is even worse, widening the drawdown by between -0.5 percent and -6.0 percent, according to Federal Reserve research.
But even as the Fed walks a tightrope over interest rates, investors can’t abandon bonds either.
The temptation is to dump bonds in this type of environment, but they still add diversification value and a steady stream of income to your investment portfolio. That’s particularly true when you own well-diversified bond funds where managers can spread their bets and “upgrade” their holdings as the investment environment evolves.
Reexamine your asset allocation to determine if you should shorten the average duration (a measure of interest rate sensitivity) of your holdings. But don’t abandon bonds altogether, because they typically offer lower volatility than stocks and throw off predictable income.
Consider adding bond funds that offer interest rate and inflation hedges to your portfolio.
We take issue with the way the US government calculates inflation, but TIPS still look increasingly attractive in the current environment. With the general consensus being that headline US inflation will likely reach 2.5 percent this year even by the official measure, TIPS will put last year’s loss as an asset class well behind them.
While there are several exchange-traded funds (ETFs) devoted to TIPS, my favorite is PIMCO 1-5 Year US TIPS Index (NYSE: STPZ).
This ETF has one of the lowest durations of any of the TIPS funds at 2.7 years, so it won’t take much of a ding based on shifting interest rates.
There are cheaper TIPS funds available, but this one’s expense ratio of 0.20 percent is average for its category. It’s also worth the slightly higher expense because its short duration also means that its performance is more correlated to shorter-term inflation expectations, which is precisely what we want in the current climate.
With solid inflation hedging characteristics and little interest rate sensitivity, PIMCO 1-5 Year US TIPS Index is a terrific hedge up to 60.