Back in 2016, Bo penned a beautiful piece on the role bonds play in our portfolio strategies. Considering the recent price declines in bonds due to rising interest rates, we thought this would be a good time to revisit the subject. We know this is a lot of info to digest, but it is important for us that you know some of the why behind what we are doing.
Bonds 101 – A Refresher
First, a quick refresher:
- Bonds are a way companies and governments can borrow money. Instead of going to a bank or other lender, they go to investors and ask them to “lend” the money to them. In turn, they issue bonds to the investors which serve as a promise to repay the principal amount, plus interest, over time. This makes bonds conservative as compared to stocks.
- All types of bonds have positive expected returns over time. Remember, however, that when interest rates move up, the price of existing bonds will go down. This is because the interest rates existing bonds are paying is now lower than the interest rates that new bonds will begin to pay. So, the value of the existing bonds must decline to entice buyers to accept the lower interest rate payments. The opposite takes place when interest rates are declining.
- Bonds are generally not correlated to stocks. This means when stock prices are declining in value, bond prices tend to increase in value, and vice versa. This happens because investors rotate between stocks and bonds based on what is happening in the economy. We covered this in some detail in the 2016 post.
Therefore, since bonds are 1) more conservative than stocks, 2) have positive expected returns, and 3) are not correlated to stocks, they make a logical companion to stocks in a balanced portfolio.
Q: If everyone knew interest rates were going to rise, why didn’t we sell our bonds to avoid the losses?
First, go back to the above refresher (and the 2016 blog post) as to why we have bonds in the first place. Then the question above begets two more questions: 1) Can we accurately forecast interest rates, and 2) Have we really experienced any losses?
As for forecasting interest rates, let us use the table below that shows the trend in different interest rates since 2012, which was a point, in hindsight, when rates were in a bottom. At that time, the Feds had lowered their short-term rate range to 0.00-0.25%, and the 10-year Treasury and 30-year Treasury interest rates had bottomed, as well.
Pause: At this point, it is important to understand that the Federal Reserve (the Fed) only has control over the Fed Funds Rate, which is the short-term rate that financial institutions (banks) use to lend each other money overnight. It’s complicated, but the point is that other interest rates (such as the 10-year and 30-year Treasuries) are not set by anyone, rather the free market determines these interest rates based on supply and demand.
Back to the table above…Starting even before 2012, many were forecasting that interest rates had to move up, and move up sharply, and therefore bond investments would suffer losses. However, see how long it took for the Feds to finally start gradually raising their rate? Now look at how the 10-year and 30-year rates responded. Proportionally they did not go up as much as the Fed Funds rate. Why? Because the free market decided that, even though the Fed was raising rates, and to the great surprise of many, proportionally higher longer-term interest rates were not required. This is supply and demand, and the free market, working at their best, and a strong case against trying to forecast future moves in interest rates!
This brings us to the next part of the question regarding losses. While it is true that the total return on bonds has been negative recently, over the last five years (while rates have been moving up) they have been positive. Below, compliments of Morningstar, is a table showing the total returns for three bond funds: One represents the total return on long-term bonds (30-year Treasuries), one represents intermediate-term bonds (10-year Treasuries), and one represents very short-term bonds (Fed Fund Rate).
In closing, a more concise answer to the big question above is this:
A: We cannot accurately forecast interest rates, we are confident that if we stay disciplined and buy high-quality bonds we will experience positive total returns over time, and there is a logical place for bonds in a balanced approach to investing.
By George W. Holland, IV