Aren’t bonds supposed to be the safe part of the portfolio? So what is this “bond bubble” we are hearing about everywhere? Well, when interest rates go up, bond prices go down. Most investors know this, and there is certainly no shortage of disturbing headlines on the subject. Here are a few:
“How Not To Get Soaked When The Bond Bubble Bursts”
“Beware The Enormous Bubble In Bonds”
“Banks’ Retreat From The Bond Market Means More Risk For Investors”
Let’s take a quick detour through a hypothetical scenario. Imagine we are playing a game of football, with some adjustments to the rules. Every time my team sacks your QB, you take the loss as usual. The twist is, every yard your team gains going forward will then be worth 1.25 yards. Then after the next sack, 1.5 yards… Then after 4 sacks, all of your yardage is worth double. In this scenario, you may actually WANT to take a few sacks along the way to benefit from the bonus yardage the rest of the game. At the very least, the potential for taking a sack would not prevent you from calling pass plays at all, right?
Now let’s translate that example to the bond world. If rates rise and your bond fund takes a 5% hit, it will then be able to capitalize on higher-yielding bonds in the market. The higher yields will help you to make up for the sack that much faster – and then be even better off going forward.
I know what you’re thinking – even in our hypothetical football game I still wouldn’t be too excited to take a sack in the 4 th quarter when the game is on the line. For those on the cusp of retirement or recently retired this isn’t a bad thought. But how long does your portfolio need to last? If you’ve just retired you probably have a good 20 or 30 years to go. Really, you may have just kicked off the 3rdquarter!
Oh by the way, about those headlines above… THEY ARE FROM 2014. In the four years from 2014 – 2017, the Barclays Aggregate Bond Index averaged a 3.18% return per year1. Investors have not been “soaked” by a bond bubble. How long does it make sense to wait? A big reason that rates haven’t risen yet is that despite how low our rates are, the U.S. already has the highest rates in the world among developed nations2. Every time our rates creep upward, money floods in from overseas, which puts downward pressure on rates across our U.S. bond market. We do believe rates will rise over the next few years, but it will likely be a more gradual ascent than most may be leading you to believe.
The thing about interest rate movement is, analysts are really good at getting it wrong. In a study of Wall Street economists over 30 years, they were asked to predict whether interest rates were going to move either up or down in the following 6 month period. In the 60 periods in the study, they were only correct in 18 of them3. All they had to do was pick “up” or “down.” They should have just flipped a coin! We don’t claim to have been able to make these forecasts any better – but that’s exactly why we don’t play that game in the first place.
You should always remember to view your investments in a portfolio context – not just a risk that your bonds are subject to. Read this next sentence carefully: the lower rates are, the greater the correlation between interest rate movement and stock prices. In other words, historical data tells us that from where we are today, it is likely that stocks will rise over the next couple years if interest rates do as well. If we want a strong economy, rising rates is part of the plan! Why should good news about the economy translate to bad news for the stock market?
So as the QB of your bond portfolio, what are we doing given the increased likelihood that the defense is blitzing?
Right now we believe in shortening the playbook and sticking to 3 and 5 step drops. In other words, shorten up your duration but don’t go crazy with it. Duration is how interest rate risk is measured. Shorter duration means bonds with shorter maturities and lower yields. They offer less upside, but when we do take that sack the damage won’t be as severe. Whatever we do, we know that trying to avoid the sack at all costs is not a good idea. Though a sack may set you back temporarily, it won’t hurt as much as making a wild throw across your body as the defense zeros in.
The opinions expressed are those of the author and not necessarily those of LPL Financial.
1 Source: Morningstar
2 Source: http://www.global-rates.com/interest-rates/central-banks/central-banks.aspx Date accessed: 2/15/2018
3 Source: Legg Mason and The Wall Street Journal Survey of Economists. This is a semi-annual survey by The Wall Street Journal last updated June 30, 2009. Benchmark changed from 30 Year Treasury to 10 Year Treasury. Past performance is not a guarantee of future results.