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On Interest and Exchange Rates
By Lon Jefferies MBA CFP® www.NetWorthAdvice.com
An interest rate hike has been widely anticipated for some time. According to an October survey of 50 top economists conducted by the Wall Street Journal, the yield on the 10-year Treasury was forecasted to rise nearly one percentage point to 3.47% by the end of 2014.
What impact would such a rise have on your investment or retirement portfolio?
The Impact
Christopher Philips, a senior analyst in Vanguard’s Investment Strategy Group, points out the historical inaccuracy of such forecasts.
For instance, a similar survey conducted in 2010 had economists predicting a 4.24% 10-year Treasury yield by the end of the year, an increase from 3.61% at the time of the forecast. In actuality, rates declines to 3.30% at year-end. The inaccuracy of these forecasts is well documented.
In fact, as Allen Roth mentioned in the December issue of Financial Planning Magazine, a 2005 study by the University of North Carolina titled “Professional Forecasts of Interest Rates and Exchange Rates” found economists predict future rates far less accurately than a random coin flip would fare as a predictor.
Clearly, we can’t be confident what interest rates will do in 2014, but what if economists are finally correct and rates rise? How damaging would an interest rate increase be for bonds? If interest rates rise one percentage point next year, the intermediate aggregate bond index is expected to lose -2.8% — far from catastrophic. Of course, such potential risk is notably minimal when compared to the downside of owning stocks (remember the -36.93% loss endured by the S&P 500 in 2008?).
Historical Performance
It is also interesting to study how bonds have historically performed in periods of rising interest rates. Craig Israelsen, a BYU professor, recently documented how bonds performed during the two most recent periods of rate increases. Israelsen points out that although the federal discount rate rose from 5.46% to 13.42% from 1977 through 1981, the intermediate government/credit index had a 5.63% annualized return during that period. The next period of rising interest rates was from 2002 through 2006, when the federal discount rate had a fivefold increase: from 1.17% to 5.96%. During this period, the intermediate government/credit index obtained a 4.53% annual return. Clearly, even in an environment of rising interest rates, bond performance was surprisingly strong.
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Most importantly, investors should never forget the value bonds add to a portfolio as a diversifier to stocks. Frequently, the performance of stocks and bonds are inversely related.
For instance, when the stock market suffered during the tech bubble crash of 2000-2002, the Barclays Long-Term Government Bond Index rose 20.28%, 4.34%, and 16.99% in those years, respectively.
Current Indices
More recently, when the S&P 500 lost -36.93% in 2008, the Long-Term Government Bond Index rose 22.69% during the year. This diversification benefit may prove useful when stocks ultimately cool off from the extended hot streak they have experienced since 2009.
In 2013, the Aggregate Bond Index decreased in value by -1.98%. Given the occasional negative correlation in performance between stocks and bonds, is it really surprising that bonds didn’t produce a positive return given the incredible year stocks had (S&P 500 up over 32%)? Additionally, held within a diversified portfolio, isn’t the -1.98% return produced by bonds during the recent equity surge a small price to pay for the additional security they are likely to provide when markets reverse?
Assessment
It doesn’t seem prudent to avoid bonds entirely during periods of expected interest rate increases.
- First, forecasts of rising rates are far from certain.
- Second, even if interest rates rise bonds are still likely to be far less risky than stocks.
- Third, rising interest rates don’t necessarily mean declining bond values are a certainty – in fact, bonds performed quite well during the past two periods of rate increases.
- Finally, bonds are a vitally important part of a diversified portfolio, and owning uncorrelated and negatively correlated assets will be critical when equities ultimately lose their momentum.
Conclusion
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Filed under: Investing, Portfolio Management | Tagged: Allen Roth, Barclays Long-Term Government Bond, bonds, Christopher Philips, Craig Israelsen, Lon Jefferies, Vanguard’s Investment Strategy Group, www.NetWorthAdvice.com |
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Update on Bonds
In January, when the broad U.S. stock market fell about 5%, and many other asset classes also declined, the broad U.S. bond market gained ground. Similarly, when U.S. stocks swooned more than 11% in mid-August last year, U.S. bonds again provided positive returns. Both periods echo what has often happened in past decades when stock markets have fallen.
But the proven diversification value of high-quality bonds (as rated by independent credit-rating agencies) can be easily overlooked, according to Fran Kinniry, a principal in Vanguard’s Investment Strategy Group.
For example, Mr. Kinniry cites Vanguard research that shows it’s hard to beat the ability of high-quality bonds to serve as a “cushion” for a portfolio when stocks tumble.
“The track record of high-quality bonds serving as a buffer to stock volatility is pretty impressive, especially compared with the other asset classes that I get asked about,” says Mr. Kinniry. “None of the others has provided downside protection when investors arguably needed it the most.”
However, two factors in ME-P readers, and all investors’ minds, may be working against consideration of highly rated bonds right now.
First, bond yields are historically low. Second, many analysts have predicted that interest rates will rise in the not-too-distant future, which would cause bond prices to fall.
Despite a three-decade bull market in bonds that many investors worry has ended, some pundits believe government and high-rated corporate bonds still remain effective diversifiers. Not only can they dilute the negative impact of falling stock prices on a portfolio, but they can also help prevent investors from overreacting to stock downdrafts.
Like the late comedian Rodney Dangerfield, who always joked about getting “no respect,” perhaps traditional, “boring” bonds are the Rodney Dangerfield of investments—overlooked but deserving more respect.
Dr. David Marcinko MBA
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Markets are dynamic
Probabilities continuously change. Months ago I argued on Marketwatch that a bond market correction would likely occur before a stock market one. Then, seemingly out of nowhere those probabilities change. Leading indicators of volatility began showing signs of strength, warning of a correction in stocks that was “inching closer.” Then very quickly Lumber began outperforming Gold, Utilities collapsed, and the yield curve began to steepen; apparently a false signal.
Bond bears have been wrong for a long time, but every bear has their day. No one seems to be expecting a sharp sell-off in fixed income is imminent, yet when looking at long duration Treasuries, it is becoming clear an acceleration of losses is likely. Commodities having already had a significant correction could be on the verge of another push higher, as emerging market momentum begins to build.
Fixed income investors have long been under the belief that they can’t lose in a zero interest rate world. But probabilities change. Central banks are now thinking about raising long duration rates and steepening yield curves, providing banks an incentive to lend. If central banks were the reason for so much yield chasing, it stands to reason they can also be the reason for yield fleeing. The stock market reaction to this changing probability is yet unclear. As discussed in our award winning papers (click here to download), stocks tend to do well in steepening yield curve/rising rate environments. I suspect this will be the case as such behavior reasserts itself. However, new leaders will likely emerge, with overseas investments and commodity related sectors likely the biggest beneficiaries in the near-term.
The October surprise may not be in stocks after all, but in the bond market. A yield spike that breaks the spirit of the bond bulls, at least for now.
Michael A. Gayed CFA
[Portfolio Manager]
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