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The Independent Adviser for Vanguard Investors
•
August 2015
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15
FOR CUSTOMER SERVICE, PLEASE CALL
800-211-7641
While current yields are near histor-
ically low levels, we know they could
still go lower. Just look back to July
2012, when the 10-year’s yield fell to
around 1.4%. Even at 2.34% yields, a
move to 1.0%, which would be signifi-
cant, only results in a price increase of
12.1%. Whereas, if interest rates moved
toward 4% or 5%, more in line with
the 10-year’s average yield over time,
today’s bond would see price declines
of 15% to 24%.
You might say that you expect to
hold your bond until it matures, so any
price fluctuation is only noise. That’s
fine, but I would remind you that if you
are buying a 10-year Treasury with a
yield of 2.20% (at month’s end), you
are locking in that 2.20% return for an
entire decade. After considering infla-
tion, which is running somewhere close
to 2% today, you’ll be earning a negli-
gible to negative real return.
Investors don’t usually jump on
opportunities that offer low future
returns with the potential for meaning-
ful drawdowns along the way—but that
is the reality bond investors face today.
The Silver Lining
Before you run to hit the sell but-
ton, let me explain why I think the
media has it wrong—rising interest
rates shouldn’t be feared, they should
be welcomed by many investors, as
they should be a benefit.
Let’s say you invest in bond funds
for total return and are reinvesting
your monthly income distribution each
month. As rates rise and prices fall,
your reinvested income is actually buy-
ing you more shares at lower prices.
As you own more shares you get more
income each month. On top of that,
each share is kicking off more income
as the fund manager invests new money
(and your reinvested dividend) in high-
er yielding bonds.
Eventually, though, rates won’t rise
any longer. Prices will stabilize. And
what you’ll find is that over time those
larger monthly income distributions
have more than made up for the initial
decline in price.
If your objective is income rather
than total return—that is, you spend
those monthly income payments
instead of reinvesting—well, you
shouldn’t really be paying attention to
the fund’s price in the first place. Even
though rising rates mean the fund’s
price is falling, you’ll still own the
same number of shares as you always
have. Plus, your monthly income is
growing as the manager reinvests in
higher yielding bonds. Yes, the price
will be down, but you’ll be getting
more income—which was your goal in
the first place.
In fact, as your income rises, you
have the option of reinvesting your
surplus income back into more fund
shares at lower prices. Remember, like
someone who gets a raise, you have the
option to keep spending at higher and
higher levels or plowing that raise back
into your investments.
That’s why I say higher rates are
something bond investors should actu-
ally look forward to.
But I get how counterintuitive that
may be, particularly after 35 years of
falling yields and rising prices. Plus,
the “beware bonds” headlines are only
going to heat up as we near a fed funds
rate hike. So let’s take this a step further
and look at how rising interest rates
coupled with reinvested income actu-
ally fared in the past.
TheTale of theTape
First, let’s consider past times the
Fed starting increasing interest rates.
Since the inception of the Barclay’s
U.S. Aggregate Bond Index—a broad
measure of the U.S. investment-grade
bond market and the index
Total Bond
Market
aims to track—there have been
six rising interest-rate cycles. Bonds
tended to stumble at first, losing 0.6%
on average over the three months fol-
lowing the initial rate hike. But the
power of reinvesting at higher levels
of income started to win out over that
initial price decline after about six or
nine months. On average, the broad
bond index gained 2.4% over the first
12 months after the Fed began raising
interest rates. Yes, on average, bonds
were up in the year when the Fed
started raising rates. Six cycles does not
make for an exhaustive study, and each
cycle is different, but it does suggest
that a Fed rate hike isn’t an automatic
death blow to bonds.
For more than three decades we
have been in a “bull market” in bonds
as generally falling rates have been a
tailwind to prices. When investors hear
that a bull market is ending, they auto-
matically assume that a bear market
will ensue. I don’t think that’s going
to happen, because I don’t see interest
rates rocketing higher.
Still, to assuage your concerns, let’s
see how bonds performed in the bond
bear market of the 1970s.
Vanguard’s oldest bond fund,
Long-Term Investment-Grade
, was
launched in July 1973. The chart below
shows the growth of a $1,000 invest-
ment in Long-Term Investment-Grade
at its inception along with the yield
on the 10-year Treasury bond over
time. When the fund launched, the
10-year Treasury yielded 6.90% and
eventually peaked (on a monthly basis)
at 15.32% at the end of September
1981 (where the chart ends). Over
this roughly eight-year stretch of ris-
ing rates, Long-Term Investment-Grade
gained 38.1%, or 4.0% a year. It’s fair
to say that yields didn’t really start
moving higher until the start of 1977,
when the 10-year Treasury still sported
a yield of 6.87%—essentially the same
as when the fund launched. In the
nearly five-year stretch from the end
of 1976 through the end of September
1981, when yields more than doubled,
Long-Term Investment-Grade returned
8.5%, or 1.7% a year. That’s nothing to
get excited about, but it also isn’t the
BondsSurvivingaBearMarket
9/73
9/74
9/75
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Long-Term Investment-Gr.
10-year Treasury Yield
$800
$900
$1,000
$1,100
$1,200
$1,300
$1,400
$1,500
$1,600
5%
7%
9%
11%
13%
15%
17%
Growth of $1,000 in Long-Term Investment-Gr.
Treasury Yield