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Putting The Bond Market Jolt In Perspective: June 30, 2013

John Gorlow | Jun 30, 2013

Focusing On Long Term Objectives Is Paramount


Fixed-income funds are where investors traditionally look for safety and low volatility. Yet, the months of May and June were challenging for many fixed income investors, especially for those who have been reaching for higher yields. For example, mutual funds that invest in long-term U.S. Treasury bonds lost on average 6.25% in May and 3.25% in June. And funds that borrow to increase returns or that invest in higher yielding sectors such as privately issued mortgage backed securities and emerging market debt securities got hit even harder during a rough patch for bonds overall.


The severity of the market’s reaction to the hint from the Fed’s chairman, Ben Bernanke, that the Fed’s quantitative easing might be tapering off sooner than expected, showed how nervous investors are about the possibility that low interest rates may soon rise, producing a bear market in bonds.


Before abandoning your bond funds consider your objectives. Making a bet on interest rates is no different than trying to predict the next big correction in stocks. Bond market efficiency like stock market efficiency has been the subject of numerous studies. The conclusions are similar: the bond market is highly efficient. There is no reliable method of forecasting future bond prices. Trading on the belief that one knows more than the market about what the price should be, explains why research shows that most investors under-perform the market. The main reason longer-term investors hold bonds is to provide a stabilizing force in their portfolios.


In equities, a common definition of a bear market is a decline of 20% in a broad market index such as the S&P 500. Most people recognize that longer term fixed income strategies are inherently more volatile than shorter term equivalents, however, if you look at a broad measure of the bond market such as the Barclay’s Aggregate Bond Market Index, which has an average maturity of 7.5 years, the worst 12 month return on record is negative 9.2% for the year ending March 1980. This loss pales in comparison to negative 67.6% for the S&P 500 during the year ending June 1932. The magnitude of these return differences speaks to the role of fixed income within a portfolio. Even though interest rates are low, a thoughtfully constructed and cost efficient fixed income allocation matched to individual risk preferences and return objectives remains the best offset to the volatility in stock prices. Despite recent talk by the Fed that agitated bond markets and led interest rates to rise, total returns on bond funds tracking Barclay’s Aggregate Bond Market Index are only down 2.5% year to date. And other fixed income funds with even shorter average maturities are performing commensurately better. The trade-off is that the shorter maturity funds generate less income which might not matter depending on why one owns bonds in the first place.


Without making any predictions about the future level of interest rates (whether up, down or sideways) basic bond math, based on the rules of duration, leads us to believe that bonds with higher coupons and shorter maturities should outperform bonds with lower coupons and longer maturities during upward moves in interest rates.


Rising Rates Environments


How have portfolios with different term and credit characteristics performed during historical periods in which interest rates rose? Using the Fed Funds rate as the interest rate proxy, consider four rising interest rate periods dating back to the 1970s that standout due to their size and persistence. The first and most extreme rising rate period occurred in the late 1970s into the 1980s. Two other cases occurred during the 1990s and the most recent period occurred in the mid-2000s.


Rising Rate Environments

Start Date

12/1/1976

9/1/1992

11/1/1998

6/1/2003

End Date

 3/31/1980

6/30/1995

12/31/2000

8/31/2007

Duration (Months)

40

34

26

51

Fed Fund Change

12.54%

2.78%

1.57%

3.80%

Barclay's Long Investment Grade

Annualized Return

-4.02%

9.11%

3.05%

3.58%

Worst 12 months

-19.14%

-8.66%

-7.18%

-6.71%

Starting Month

Apr-79

Nov-93

Feb-99

Jul-05

Growth of a Dollar

$0.87

$1.28

$1.07

$1.16

 Barclay's Intermediate Investment Grade

Annualized Return

1.10%

7.30%

4.92%

3.10%

Worst 12 months

-6.67%

-2.80%

-1.05%

-0.61%

Starting Month

Apr-79

Nov-93

Feb-99

Jul-05

Growth of a Dollar

$1.04

$1.22

$1.11

$1.14

 Barclay's Long US Gov't

Annualized Return

-3.53%

10.07%

4.72%

3.35%

Worst 12 months

-16.06%

-11.75%

-8.73%

-6.32%

Starting Month

Apr-79

Nov-93

Jan-99

Jun-03

Growth of a Dollar

$0.89

$1.31

$1.11

$1.15

Barclay's Intermediate US Gov't

Annualized Return

2.30%

0.12%

4.98%

2.72%

Worst 12 months

-1.28%

-1.75%

-0.29%

-0.89%

Starting Month

Apr-79

Jan-94

Feb-99

Jun-03

Growth of a Dollar

$1.08

$1.17

$1.11

$1.12


Using the rules of duration as our guide, we might have expected shorter maturity and higher coupon bonds to outperform in the rising interest rate environments, all else being equal. However, as the table reveals, all else has rarely held equal. This is the key point. Sometimes shorter term bonds outperform when rates increase and sometimes longer term bonds do better. The results are decidedly mixed and the rules of duration do not always hold.


It is not just changes in the level of interest rates that matters, but also changes in the shape of the yield curve and changes in the spread between lower quality (Corp) and higher quality (Gov’t) bonds. So even as rates fluctuate, term and credit spreads can widen and narrow, affecting fixed income returns in unpredictable ways


Conclusion


Since there is no reliable method of forecasting future bond prices, it’s a futile game to base portfolio moves on interest rate guesses. Interestingly, after the great depression, interest rates remained low for 15 years; a salient fact to contrast with current rumors that interest rates are imminently on their way back up. But for how long? One may wonder. For most investors, avoiding more volatile longer term fixed income strategies and holding a smart and diversified mix of short and intermediate term bonds through low cost index funds is a prudent course.