Seven myths of the bond market

Are higher rates bad for bonds? Don’t believe the myths.

Summary: Although the timing of the next official interest rate move in Australia is difficult to predict, most economic commentators believe the move will be up. Will this be bad for bond returns? Below, we bust seven myths around bonds and rising rates.
Key take-out: Bond market investors have been able to see a modest but almost certain return of 6.8% per annum over the last 20 years, with minimum volatility.
Key beneficiaries: General investors. Category: Fixed interest.

Bond markets were supposed to have been sold off by now. But values have settled over recent months and there is evidence to suggest a carefully managed bond portfolio will pay handsomely in years to come.

Further, evidence that the anticipated lift in interest rates both locally and overseas may take a lot longer than many realise is mounting.

Just last week in Australia the consumer price index – a key measure of inflation – came in below expectations.

More to the point, to everyone’s surprise the inflation rate at an annualised 2.9% remains with the RBA target band of less than 3%.

On Wall Street, Treasury yields were supposed to rally – and they did for a few months, reaching what now looks like a peak when US 10-year treasury yields hit 3.05 % in January,

But after new US Federal Treasury Secretary Janet Yellen revealed recently she was in no rush to lift rates, US treasury yields have drifted back to 2.7%, their lowest level in more than a year.

What’s happening ? Well, it just might happen that interest rates will be slower lifting this time round. Certainly, that’s the way the world’s central banks wish it to happen, and just now they have enormous leverage with an unprecedented level of uniform strategies aimed at resurrecting the global economy in the wake of the GFC.

For bond market investors, this translates simply – an expected rise in bond yields and consequent fall in bond prices (values) is not happening in any significant manner. Moreover, it may not happen too soon.

Already the outcome is emerging as a lesson for all investors – the bond market is not to be ignored short term or long term.

Today I thought I would take a look at some of the most important lessons every investor should know.

The way I look at it, there are seven myths of the bond market and most of them hinge on the notion that somehow a rising interest rate cycle means bad news for bond markets.

It’s the perfect time to expose these myths for what they really are … here goes.

Myth 1: … bond markets will collapse

As the focus moves to the possibility of rising rates, there are increased fears about an impending bond market collapse. But a comparison of some of the worst 12-month returns between stocks and bonds (figure 1) shows that shares are more likely to see big negative returns during a downturn in the sharemarket compared to a downturn in the bond market.

Figure 1: Shares have seen larger downturns

Graph for Seven myths of the bond market

Source: UBS, Bloomberg, Data from 1993 to 2013

Myth 2: …shorten duration

Capital losses in a bond portfolio from rising rates can be offset by higher yields. Although shortening maturities or duration may preserve the principle, it could lower income over time. Forecasting interest rate changes with respect to direction and size of interest rate movements is difficult, as can be seen by the current level of debate over the next likely rate move by investment professionals. And by targeting shorter durations, there can be the risk that interest rates stay low for a while and there will be an opportunity cost of missing out on higher yields, or that short-term rates may rise faster than long-term rates. But shorter duration bonds can facilitate any short-term liquidity requirements.

The outlook for bond returns can be predicted by the yield to maturity. Looking at the bond market, as represented by the UBS Composite Bond Index, we can use the current yield of the 5-year government bond as a good indicator of the annualised returns for bonds over the next five years (see Figure 2 below, which shows the strong relationship between current yields and subsequent long-term returns). While interest rate movements can impact short-term performance, as has been the case with recent above-average historical returns, over the long run current interest rates are good predicators of future returns.

Figure 2: Today’s yields are good predictors of long term returns for bonds

Graph for Seven myths of the bond market

Note: The 5-year government bond was used as it has similar characteristics with respect to duration as the UBS Composite Bond Index, which has been used to represent the bond market.

Source: UBS, Bloomberg, RBA

Myth 3: … shares do better

Rising interest rates may be seen as depressing returns from the bond market due to the impact on bond prices. But reinvestment in higher-yielding bonds, and the capital stability if held to maturity, contribute to lower volatility, which can benefit a portfolio’s return over the longer term. There are no guarantees that shares will do better when interest rates go up. In fact, the positive relationship between the sharemarkets and interest rates has not been consistent over time.

If interest rates rise and the valuations of shares are high due to prior price-earnings expansion, in the absence of stronger earnings, there is unlikely to be a continuing strong sharemarket. There is an argument that earnings will be positively affected by higher inflation, meaning shares will do better due to higher interest rates leading to falling P/Es. But the reason for higher interest rates is important as to how the sharemarket will respond, and is likely to be more positive for shares if higher interest rates are caused by a strong economy rather than by inflation.

Myth 4: …bonds lose their safe haven status

Investing in any type of security is not without risk. Bonds are often considered as providing a safe haven in times of extreme sharemarket volatility, due to the characteristics of capital preservation and income protection. Even when sharemarkets are doing better than bond markets, a bond investment may moderate market volatility (the volatility of shares is four times that of bonds). Over the longer term an allocation to bonds in a portfolio may contribute to a relatively attractive stable return, buffering sharemarket swings.

Myth 5: …bonds require a large investment that is tied up to maturity

This is not strictly a myth, as investing in unlisted bonds requires an investment of up to $50,000 for a single bond. Bonds can be sold prior to maturity, although interest rate movements affect their market value. This can result in a gain or loss being incurred if they are sold before their maturity date. In order to minimise the effects of interest rate fluctuations, holding bonds to maturity may be the best option. Additionally, select bonds with maturity dates that coincide with your short- and long-term income and capital objectives. It would be unwise for a 70-year-old investor to invest in a bond investment that matures in 30 years. You also can buy listed bonds and hybrid securities, which require a smaller outlay relative to the unlisted market.

Myth 6: …capital is protected.

Capital is protected to the extent that, if a bond is held to maturity, the face value of the bond will be received by the investor, subject to no default by the issuer. But if you have to sell before maturity there may be a capital loss due to the inverse relationship between bond prices and yields.

The risk of default is low for investment grade bonds (credit ratings BBB- and above), with no defaults in Australia recorded in 2012 according to Standard and Poor’s (S&P) and 84 defaults out of 6,000 securities in the S&P global bond universe (none of the defaults being investment grade). The increase in number of defaults usually occurs when sharemarkets are weak, a reflection of the health of the economy. There was an all-time high of 265 defaults globally during the 2008 financial crisis.

Myth 7: …ditch your bonds and buy shares.

An investment that is 100% invested in shares over the long term may produce a higher total return (see figure 3 below). But that is only if the investor can commit to the long term, without being forced to sell (which is not always foreseeable).

Even if shares are held for the long term, there can be years of negative returns in the sharemarket (for example, following the financial crisis of 2008), with investors at risk of being exposed to big losses that can take years to recoup. Bond market investors have been able to see a modest but almost certain return of 6.8% per annum over the last 20 years, with minimum volatility. While share investors have seen higher returns of 9.1% per annum over the same 20 years, this has been accompanied by significantly higher volatility. A portfolio invested in a mix of shares and bonds still produced a reasonable return over 20 years, but with more moderate risk than a 100% share invested portfolio.

Figure 3: $100,000 invested in shares and bonds over 20 years

Graph for Seven myths of the bond market

Note: This does not represent an investment recommendation. For illustrative purposes only.

Source: UBS, Bloomberg, Eureka Report calculation

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