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the past 30-plus years, when interest rates fall, bond prices rise. But the opposite is also true. When interest rates rise, bond prices fall. So it would only be natural to expect that as the Fed begins raising the fed funds rate, bonds will struggle. In the first chart on the right, I took each of the six rising rate periods iden- tified above and looked at the perfor- mance of Total Bond Market over the two years following the first increase in the fed funds rate. I also showed the average performance of bonds over these time periods. (As Total Bond Market was launched in November 1986, I used the fund’s benchmark, the Barclays U.S. Aggregate Bond Index, as a proxy for those periods before the fund was available.) The chart may at first appear noisy, but before focusing on any one year, step back to gain a sense of the pat- tern and range of returns we’ve seen from bonds following a hike in inter- est rates. Remember, we are looking to history as a guide for setting our expectations. The pattern that emerges is that bonds struggle a bit in the first few months following the initial increase in the fed funds rate, as rising rates pull bond prices down—on aver- age, Total Bond Market lost 0.6% in the first three months following a Fed rate hike. But there is a silver lining to ris- ing interest rates—higher interest rates mean higher yields. And as an investor in a bond fund, you can easily reinvest interest payments at those higher rates. At the same time, the fund’s portfolio manager is investing the money from maturing bonds into bonds with higher coupons as well. Over time, that higher level of income can make up for the initial decline in prices. On average, Total Bond Market gained 2.4% in the first year following the initiation of a Fed rate hike, and was up 12.4% over the average two-year period after the first hike. The range of returns in the two years following the initial rate hike was 6.1% to 22.6%. The rising rate cycle in 1994 was the most difficult for bond investors. This was a sharp and quick rise in interest

Bonds Feel Initial Pain, But Time Heals

Stocks Continue to Gain as Rates Rise

25%

-20% -10% 0% 10% 20% 30% 40% 50% 60%

1976 1986 1999 Avg.

1983 1994 2004

1976 1986 1999 Avg.

1983 1994 2004

20%

15%

10%

5%

0%

-5%

-10%

0 2 4 6 8 10 12 14 16 18 20 22 24 Months Following First Rate Hike

0 2 4 6 8 10 12 14 16 18 20 22 24 Months Following First Rate Hike

rates—the fed funds rate doubled from 3.0% to 6.0% in only 13 months. At its worst, Total Bond Market was off 5.0% through the first five months of that cycle. That’s not what most investors are looking for out of their bond funds, but a loss of that magnitude ought to be tolerable for any long-term investor. If you held on, you recovered your losses in short order, and two years after the first rate hike in 1994, Total Bond Market investors were up 14.2%. The lesson to take away is that the bond market typically takes a few months to digest a change in Fed pol- icy, and bond prices suffer as a result. But investors who persevere (and rein- vest) go on to recoup those modest early losses and reap rewards for doing so. In my view, that’s a reasonable expectation for the next rate-hike cycle. Stocks Post Modest Gains Concerns about a new rate-hike cycle don’t stop with bonds, though. Some pundits argue that stocks and the economy have benefited in lockstep from the Fed’s easy monetary poli- cies, and hence will suffer without that support. I should note that many of these same pundits also have said that the Fed’s quantitative easing programs have been ineffectual, so I’m not sure which side of the argument they’re really taking—except whichever side supports the notion that only bad things can come from policymakers’ moves. In the right-hand chart above, I’ve run the same analysis for 500 Index as I did for Total Bond Market. Like bonds, stocks weathered rising rate

cycles reasonably well. On average, 500 Index was up 4.1% in the first six months following the start of a rate hike, up 1.9% after 12 months and up 15.2% two years later. Now, that’s an average. The range of outcomes for stocks was wider than for bonds, as we would expect, with returns ranging from -1.1% to 39.1% over the two years following the start of a rising rate cycle. The lowest point for long-term investors was a 10.4% decline reached 15 months after the 1976 rate hike cycle began. It is worth highlighting the extreme moves you see if you look at the 1986 cycle in the chart. The period includes Oct. 19, 1987, Black Monday, when stocks fell by over 20% in a single day. First, given that this occurred 10 months after the Fed started raising interest rates, I don’t think you can pin the cause on a rising fed funds rate. Second, note that despite the Black Monday decline, investors were still up 16.5% two years after rate hikes began. As with bonds, the start of a rising- rate cycle did not historically spark a bear market decline in stocks if you had the wherewithal to take even a two-year view, much less a longer-term perspective. Cash Can Be Expensive Still, you may be thinking that you’d rather just sidestep any potential dis- locations and put your portfolio in cash. As longtime FFSA members can probably guess, I don’t think this is a great idea, nor easily executed. In >

The Independent Adviser for Vanguard Investors • August 2014 • 5

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