The Independent Adviser for Vanguard Investors
•
August 2014
•
5
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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
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
Bonds Feel Initial Pain,
But Time Heals
0 2 4 6 8 10 12 14 16 18 20 22 24
Months Following First Rate Hike
-10%
-5%
0%
5%
10%
15%
20%
25%
1976
1986
1999
Avg.
1983
1994
2004
Stocks Continue to Gain as
Rates Rise
0 2 4 6 8 10 12 14 16 18 20 22 24
Months Following First Rate Hike
1976
1986
1999
Avg.
1983
1994
2004
-20%
-10%
0%
10%
20%
30%
40%
50%
60%
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