What Would an Interest Rate Rise Mean for Bonds?
On January 31, 2013, the yield on the 10-year Treasury bond stood at 2.00 percent, an increase of 62 basis points (0.62 percent) since the low hit in July 2012. However, the yield remains much lower than the 10-year average of 3.70 percent. With the December Core Consumer Price Index rising 1.9 percent year-over-year, inflation-adjusted bonds for the next five years are trading at a negative real yield. Yet, inflows into fixed income investment vehicles continue to outpace inflows into stock investment vehicles (which have seen net outflows since 2007). With bonds having experienced a three-decade long bull market, investors continue to overlook the risks inherent in bonds at their current low yields
- In order to attempt to quantify the amount of losses that an investor could experience on a bond holding, it is helpful to look at past experiences during which interest rates rose. In a study published by Welton Investment Corporation, the firm examined how seasoned Aaa-rated bonds performed when interest rates rose by at least 1.5 percent. Since 1920, this scenario has occurred eight times. The largest increase occurred in the mid-70s as interest rates rose by 7.6 percent from trough-to-peak. During that time period Aaa-rated corporate bonds lost 24 percent of their value.
- In a rising interest rate market, short term fixed-income securities typically outperform long term fixed-income securities. The reason for this is that investors have a shorter time to wait to receive their principal back, at which time they can re-invest the proceeds into newly issued fixed-income securities with higher coupon rates. For this reason short duration bonds (and bond funds) have become popular lately as investors are worried over the possibility of rising interest rates and inflation. Despite their nominal growth of 7.34 percent from 1973-1980, Treasury bills experienced an inflation-adjusted loss of 1.54 percent. Although this was the best return for any type of fixed-income security from 1973-1980, this still left an investor with less purchasing power at the end of 1980 than he or she had in 1973. Consequently, Treasury bills were not the panacea during this time period, and they most likely would have attained worse returns if economic growth accompanied the higher interest and inflation rates.
- Over the past three decades, one fact regarding high yield bonds that has become apparent is their relatively high correlation to equities. Correlation is the measure of the linear relationship between two variables. Correlation can range between +1.00 for perfect positive correlation and -1.00 for perfect negative correlation. For example, if two stocks or sectors had a correlation of .90 then that means their prices have moved in tandem 90 percent of the time. Historically, U.S. high yield bonds have a correlation of .62 with the S&P 500 Index. In comparison, U.S. investment-grade corporate bonds have a correlation of .21 with the S&P 500 Index, and U.S. Treasury bonds have a correlation of -.31 with the S&P 500 Index. Despite their high correlation with U.S. equities normally, this correlation has tended to increase during times of market volatility. In 2008, the correlation between high yield bonds and stocks averaged .88 – both sold off heavily. The S&P 500 Index ended 2008 down 38 percent while U.S. high-yield bonds fell by an average of 25 percent.
*The opinions and forecasts expressed are for informational purposes only and may not actually come to pass. This information is subject to change at any time, based on market and other conditions and should not be construed as a recommendation of any specific security or investment plan. The representative does not guarantee the accuracy and completeness, nor assume liability for loss that may result from the reliance by any person upon such information or opinions. All investments involve the risk of potential investment losses and no strategy can assure a profit. Past performance is not indicative of future results.
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