What Happens When Interest Rates Rise
Given historically low U.S. interest rates, government stimulus efforts that seem likely to spark inflation and a massive flow of cash chasing returns, many investors think that it is not an ideal time to invest in U.S. bonds.
But does that mean that investors should move away from existing U.S. bonds holdings or avoid investing any new money in bonds?
U.S. bonds are not a compelling investment currently for a few reasons:
- A very long bull market for bonds is running out of support from fundamental market factors that drive value
- Massive cash inflow has flooded bond markets with buyers, driving prices up
- Interest rates have nowhere to go but up, hurting bond prices
The interest rate concern seems to be the biggest, especially for investors who remember 1994 when many U.S. bond mutual funds lost money even after considering the income their bonds paid out.
Compounding the lack of clarity is the uncertainty of actual increases in interest rates. Bill Gross, manager of the PIMCO Total Return Fund, the largest bond mutual fund in the world, believes that the Federal Reserve will not be faced with a need to raise interest rates for at least another year, potentially well in to 2012. He is not alone in this assumption.
There’s also no telling how fast rates will rise once the economy seems healthy on its own unstimulated merits. Gross is far more worried about the economy and its impact on the U.S. stock and bond markets than he is on interest rate changes. Unemployment will have to come down and inflation will have to be more obvious before there is pressure to raise rates. If the recovery continues to be a jobless one, we could continue in our low interest rate environment for a long time.
It’s possible that short-term interest rates and long-term rates could take different paths. The Federal Reserve manipulates the economy and markets to influence short-term interest rates but the market itself has more influence on long-term interest rates.
Past bond market performance gives us an indication of what returns we may expect when interest rates rise (causing the value of many types of bonds to fall). The trouble is that previous cycles of climbing interest rates weren’t also paired with unemployment, deficits, an economy boosted by artificial stimulus, and political combativeness, all at the same time.
A REMINDER THAT BONDS CAN LOSE VALUE
In 1994, many investors thought that bonds would protect them from loss. This is true if you own individual bonds and hold them to maturity, collecting coupon payments along the way and retrieving the principal of the bond at maturity. But if you have to sell your bonds or the bond mutual fund you own sells bonds, they could be sold for less than their purchase price.
In February 1994, U.S. interest rates began a relatively swift climb. They increased from 3.0% to 6.0% in one year. In that time, the Vanguard Total Bond Market Index Fund had a total return of -1.51%. Declines in the price of the fund outweighed income paid out by the fund for a full year.
We don’t think that it is likely that once interest rates do begin to climb, that they will increase 3% in a year, but it is still a possible scenario.
A MORE LIKELY INCREASING RATES SCENARIO
It was just a few years ago that interest rates reached their most recent peak. In July 2004, interest rates climbed from 1.0% to 1.25%. They continued to climb until September 2007 when they peaked at 5.25%.
Bond mutual funds fared much better in this period than during 1994:
| Fund |
Cumulative Total Return (income + price appreciation) from July 1, 2004 – Sept. 4, 2007 |
| Barclays Aggregate Bond Index ETF |
13.5% |
| Vanguard Total Bond Market Index Fund |
14.19 |
| Vanguard Long-Term Bond Market Index Fund |
18.80 |
| Vanguard Short-Term Bond Market Index Fund |
11.69 |
| iShares 1-3 year Treasury Bond ETF |
11.03 |
| PIMCO Total Return |
16.44 |
| Fidelity Strategic Income |
25.99 |
| Templeton Global Bond |
39.36 |
| Vanguard Total U.S. Stock Market Index Fund |
42.41 |
This was not a period of exceptional bond returns. If you divide the cumulative total returns by three you get a rough annualized return. There were some reasonably good returns, particularly for non-Treasury bonds. Foreign bonds and corporate bonds in general that were not punished by the increasing interest rate environment.
Let’s take a closer look at the experience of the PIMCO Total Return Fund, managed by Gross. From July 1, 2004 through September 4, 2007, the fund had a price return of -2.24% but a total return of 16.44%.
If you invested $10,000 in this Fund, just as interest rates began to climb in July 2004 and reinvested dividends over the three years, the fund paid out $1,831.52. The negative price impact left the investment’s value at $11,605.72 on Sept. 4, 2007. While the total return is not significant, it did continue to outpace inflation. Reinvesting dividends also added 174 shares to the holding over the period, increasing future growth.
Certainly there are differences between our economic situation today and the previous two climbing-interest rate environments. We are coming out of a deeper recession and the market will have to deal with the impact of massive cash stimulus (quantitative easing) that was not a consideration in 1994 or 2004-07.
If we rewind the calendar for a full generation, back to 1973, we can see how the U.S. bond market performed in a wide variety of economic conditions, market expectations, and political changes.
In the 37 years since then, the Barclays U.S. Aggregate Bond Index has had a negative return over a calendar year three times (-2.91% in 1974, -2.92% in 1994 and -0.82% in 1999). The 37-year average annual return was 8.22%.
Part II Portfolio Management Preferences to Reduce Risk
Past performance does not guarantee future results.
~ Gary Brooks, CFP®, Allyn Hughes, CFP®, and Nancy Jones, CFP®, — Brooks, Hughes & Jones, Partners in Wealth Management, Tacoma, WA
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