Time is a powerful modifier of perception and purpose. No need to look any further than the frequent rumblings surrounding fixed income in the current rising interest rate environment.
That isn’t to say the frequently touted “bond bubble” and rising interest rate topics are unimportant or overstated, it’s merely a reaction to the volume and misappropriation of focus often exhibited in these ongoing conversations. Monitoring the trajectory of rising interest rates is a good idea, however letting it affect the way you invest in fixed income may not prove additive in the long term.
Generally speaking, fixed income, aka bonds, react in direct opposition to interest rate movement. That is to say, when interest rates go up, the price of bonds go down. That much is easy enough to understand considering the structure of these investment vehicles: a bond is a loan and, if held to maturity, allows the investor to know the return on investment (interest paid on the loan or “coupon”) at the time of purchase. However, the purpose and value of fixed income, relative to one’s overall portfolio, can be easily forgotten considering the market environment over the past 30 years. Interest rates over this period exhibited a relatively steady decline while the Bloomberg Barclay’s U.S. Aggregate Bond Index¹, the most common benchmark by which fixed income is compared, returned an annualized average of 6.31 percent². This near equity-like level of return on investment has led to an environment that has fostered a viewpoint of looking at bonds in a similar fashion as equity, when in fact their primary function in the context of a well-diversified portfolio is entirely different.
Let’s take a step back and revisit two fundamentals of portfolio construction: 1) the role of equity (stocks) in a portfolio is wealth accumulation, 2) the role of fixed income (bonds) is wealth preservation. As we continue into the early stages of a rising interest rate environment, expectations have to be retrained and refocused. From a macro long-term outlook, fixed income should reduce volatility while providing income. Equity is generally more volatile and provides the source from which one hopes to generate greater return. Proper balance between the two is determined by a number of metrics and is personal in nature, but none more so than proximity to retirement and risk tolerance.
Now we can return to the aforementioned end of the bond bull market and interest rates on the rise. Does this in any way change the purpose and function of fixed income? I would argue the answer is a resounding no. Fixed income provides a hedge against the higher risk/volatility of equities. The functional relationship of bonds to equity remains unchanged. Thus, the viability and benefit for consideration and inclusion within a well-diversified portfolio also remains unchanged.
It merits mentioning that not all fixed income instruments bare equal sensitivity to interest rate movement. Longer duration or time until maturity is certainly one of the primary factors to consider, however it also isn’t the end-all de facto. Bond categories with low correlation to U.S. government debt have historically fared better than those with high correlation. High yield and bank loans may be particularly resilient options for income seeking investors in times of rising rates³.
Attempting to time the markets as a strategy is about as viable a solution as relying on Punxsutawney Phil for reliable weather forecasts (Phil has worse accuracy than a coin flip (39 percent⁴) in case you were curious). Consider the following historical data as it relates to what happens just after the initial negative effect rising interest rates have on bond prices in the short term: out of the 19 periods of rate increases dating back to 1979, the Bloomberg Barclays U.S. Aggregate Bond Index actually saw improved returns 17 times in the year that followed (returns between less than 1 percent and 35 percent, and an average return of more than 10 percent)⁵.
The complexities that affect market fluctuations and interest rates, can and should be analyzed when making prudent investment decisions. However, keeping a macro view firmly in place when it comes to investment characteristics will help maintain expectations and provide context for fiduciary and participant decisions alike.
So before the media chatter of “the sky is falling” spooks you into getting out of fixed income, consider the possibility this “scary movie” might just end up rated G.
