Does this quote sound familiar, like something you may have read recently?
"Interest rates in many OECD countries are at, or are close to, record lows. However, with inflationary pressures beginning to build, most investors expect the major central banks to begin raising interest rates soon."
It's from a J.P. Morgan Asset Management commentator dated August 2011. Yes, seven years ago. Since then, Treasuries have alternately rallied and sold off, all the while offering yields within a fairly narrow and relatively low band.
So, we'd argue that we've been here before. Once again, even though yields on U.S. bonds have doubled since mid-2016, rates still appear poised to rise further. And bond investors are again wondering how to handle this environment. It's easy to fear rising rates, which could mean lower bond prices, which in turn could mean losses for investors, right?
As long-term investors, we encourage bondholders to stay rational, regardless of the market environment, and offer some thoughts on how – and why – we're investing in bonds today.
We've Been Here Before
It seems that, according to the pundits and media, interest rates have been about to rise since shortly after the markets started to recover from the Global Financial Crisis. In fact, in early July 2009, the 10-year U.S. Treasury rate had been recovering for two months only to finish the month down and on its way down to even lower levels.
Eager to return to normal, bond market observers witnessed three more periods that might have tricked them into believing "normalisation", or a return to rates more in line with the historical average, lay around the corner.
We believe bond yields will eventually trend higher and revert to our estimate of fair value, but we can't predict, nor can anyone, the path or timing. The danger here is trying to time the market by exiting bonds in an attempt to re-enter when interest rates normalise.
Additionally, even with a muted return outlook, we think bonds play a valuable role in a diversified, multi-asset portfolio. Therefore, we've maintained bond exposure across our portfolios, but we've taken steps to mitigate the potential losses caused by rising rates.
Bond Drawdowns vs Stock Market Crashes
There are at least two good reasons to keep bonds in your portfolio, in our view. First, bonds historically haven't given up nearly as much ground as stocks have during their worst respective drawdown environments. In other words, owning bonds when valuations are stretched is likely to be less detrimental to total portfolio returns compared with owning stocks at high valuations.
Moreover, as shown below, because bonds tend to hold their ground when stock markets crash, they can also offer important ballast to multi-asset portfolios holding stocks in uncertain and volatile times.
In today's markets, when we'd argue a large portion of the equity market is overvalued, we like the diversification features and potential buffer that high-quality bonds can offer when equities sell off, even though our return expectations for Treasuries are relatively low.
But it's not just about staying invested in bonds – it's also about picking the right bonds to invest in. Some fixed-income asset classes have fared better than others in rising rate environments. For the next two graphs, we look at 19 rising-rate periods since 1998 to compare performance of different fixed-income asset classes.
First, we see that short-term bonds, which carry less duration, or interest-rate sensitivity, tend to outperform the broad bond market. Overweighting short-term bonds can offer the potential to minimise losses should rates move meaningfully higher, while continuing to provide capital preservation properties that high-quality bonds tend to offer during volatile market conditions.
Additionally, there are other fixed-income asset classes we can introduce to a multi-asset portfolio to mitigate its overall interest-rate sensitivity. We find that local-currency emerging-markets debt, which generally displays less sensitivity to developed market rates and lacks direct ties to U.S. monetary policy, has offered investors a considerable yield difference in the past over bonds issued by the U.S. government, as well as a diversified pattern of rate movement over time.
While introducing other risks that must be evaluated, when trading at relatively attractive valuations, local-currency emerging-markets debt can help shield a portfolio during a period of rising U.S. interest rates.
Rising Rates Good for Long-Term Investors
It's important to remember that rising rates means borrowers will pay investors more to hold their capital. As rates move higher, short-term debt rolls over to higher rates and investors can ultimately get paid more, but only if they stay invested. Comparing the hypothetical growth of $10,000 over a 10-year period; one in which rates remain unchanged at 3% versus enduring a 2% rate increase in Year 1, followed by 10 years of yielding 5% and we find that an investor ultimately earns more in the second scenario.
We’ve sought to manage interest rate risks in our portfolios while preserving return potential. But the larger issue may be a behavioural one, as it often is; it's easy to fear rising rates and rashly trade out of bonds. This would be a mistake in our opinion, as we can't know the future. The path to higher rates is anything but certain, and bonds can play an important role in most market environments.
