With interest rates near historical lows, investors might be concerned about the potential impact on their bond investments from rising interest rates in the future. Rising interest rates typically cause existing bonds to lose value. As you read the financial headlines and evaluate your current fixed income exposure, it may be helpful to consider these principles about fixed income investing:
Academic research offers strong evidence that the bond market is efficient, and that bond prices and interest rates are not predictable over the short term. This uncertainty is reflected in the often-contradictory interest rate forecasts offered by economists, analysts, and other market watchers. Even when the experts share similar views on the direction of the economy and credit markets, reality often proves them wrong. Recent history is a good example, despite many experts predicting a jump in rates a few years ago and again as recently as late last year, the yield on a 10 year government bond is lower today than at the end of 2013, 2014 and 2015.
Today’s bond prices already reflect expectations for tomorrow’s business conditions and inflation, and these expectations can change quickly in response to new information. This new information is unknowable. Investors who accept market efficiency should not be surprised when the credit markets foil the experts. If prices were easy to forecast, you should find a host of fixed income managers with market-beating returns. But most of them underperform their respective benchmarks over longer time periods. In fact a recent study indicated that only 7% of bond funds survived and beat their benchmark returns over the past 15 years. Since no one has a reliable method for determining whether interest rates will rise or fall in the near future, investors should avoid making fixed income decisions based on a forecast, media coverage, or their own hunches.
The strong link between risk and return appears in all properly functioning capital markets. When investing in stocks, bonds, or other assets, investors must accept more risk to pursue a higher potential return. In the fixed income markets, earning a return above short-term government investments is usually a function of assuming more term and credit risk. Term risk refers to a bond’s maturity, and credit risk refers to the creditworthiness or default potential of the borrower. Bonds with longer maturities and lower credit quality are usually considered riskier and have offered higher yields and returns to compensate investors for higher risk.
On the term side, investors who commit their capital for longer periods of time are exposed to the amplified effects of changing interest rates. Bond prices and interest rates move in the opposite direction: When rates rise, the value of an existing bond declines; when rates fall, bond values rise. The market adjusts the price to match the yield available on a new instrument. The longer the bond’s maturity, the greater the price adjustment for a particular interest rate change. A long-term bond is more exposed to rate changes than a short-term instrument, and usually (but not always) offers a higher yield to compensate investors for the extra risk. Also, lower-coupon bonds are more affected by interest rate changes than higher-coupon bonds. For example, if rates move 1%, a bond that pays 3% will experience a greater gain or loss than one paying 5%.
On the credit risk side, the government is considered the strongest borrower in the market, so it has a lower cost of capital relative to other issuers. The most creditworthy companies are considered relatively safe, but they must still offer a higher rate than the government to compensate investors for taking more default risk. The weaker a corporate borrower’s financial condition, the more it must pay in yield to attract investors. Investors seeking higher returns on the credit spectrum must bear a higher risk of default.
Investors may hold fixed income securities for a variety of reasons—for example, to reduce portfolio volatility, generate income or to maintain liquidity. Each objective may involve a different portfolio approach, or a combination of strategies to manage tradeoffs. For example, investors who want to maximize current income may not be strongly concerned with the effects of short-term price volatility. They may extend maturity or accept slightly lower credit quality to get higher yields. On the other hand, investors seeking long-term growth with a portfolio mostly in stocks should keep their bonds short term and high quality to buffer portfolio volatility. Regardless of your approach, you should know the difference between controlling risk and avoiding it. You cannot eliminate risk, but you can manage your risk by the types of bonds in your portfolio.
Many factors influence the direction of interest rates and performance in the bond markets, and these are too complex for anyone to reliably predict. Rather than placing your faith in the experts or reacting to economic news, manage your fixed income component from a portfolio perspective. Your strategy should reflect your overall investment goals, risk tolerance, and other personal financial considerations. This is a better approach to managing your portfolio in an uncertain interest rate market vs. reacting to the latest headlines.