Bonds are an important ingredient in many portfolios. Most people, in fact, the closer they get to retirement or having to pay for college, find themselves shifting from stocks, which promise higher returns but also greater volatility, to bonds, which offer lower returns along with lower volatility. Bonds can help insulate our savings from sharp downturns in the market, and this is exactly what we need when we no longer have the luxury of waiting for our portfolios to recover (e.g., when we are approaching retirement or when that first tuition payment is around the corner).
But now is a tricky time to invest in bonds: not only are yields disappointingly low, but bond prices are largely falling as interest rates rise. This is a new experience for most investors. From 1982 through 2015, a period of 34 years, interest rates were falling and bond prices were rising. Many of us have only ever known what it is like to live in a bond “bull market.” But things have now changed, though there are some definite plusses mixed in with the minuses.
Bonds: A Quick Primer on Yields v. Prices
First, a little primer on the bond market. As I have hinted already, bond prices and bond yields (the interest rates you receive on bonds) move in opposite directions. It might seem counterintuitive at first, but it does make sense on further reflection. If you own a bond worth $1000 earning 4% per year in interest, and prevailing interest rates go up to 5%, what happens to the value of your bond? It goes down. Fewer people want your bond earning 4% because they can now get 5%, so they are willing to pay less for your bond. The opposite holds true if prevailing interest rates decrease. It is ultimately all about supply and demand.
How much does the price of the bond go up or down? It is a little complicated, but it has to do with a concept known as “duration.” Duration is basically the period it takes for the investor to recover the original price of the bond (through interest payments and principal repayment), which is usually a bit less than the actual maturity of the bond or the average maturity of all bonds in a bond fund. If the duration is 4 years, then the value of your bond will go up about 4% if rates decrease by 1% and will go down about 4% for every increase in rates of 1% (keep in mind that rarely do rates move that quickly; the Fed lately moves by ¼% at a time, and their movements do not always move the market by that amount).
What is the solution to bond investing in a time of rising interest rates? One possibility is to hold individual bonds to maturity. If you hold a bond to maturity, you will receive the face value (commonly $1,000) at maturity and will not suffer any decrease in value. This is not a bad strategy for U.S. government bonds, but I am not crazy about doing this for corporate bonds; if a corporation defaults on its bond obligation, there will be no guarantee of receiving that $1,000 face value at the end or indeed receiving anything at all. For clients who want to have exposure to the higher-paying corporate bond market, I typically recommend they buy a bond mutual fund or ETF, which provides built-in diversification. And to be honest, I think this is a good way to invest in government bonds too.
Of course, if you invest in bond funds, you are back to being exposed to the risk of dropping prices as interest rates rise. But there is a solution to this problem: hold the fund for long enough that the cumulative interest payments more than outweigh the small drop in price per share. And the period we are talking about, at which one “breaks even” and achieves the initial promised rate of return, is approximately the average duration of the bond fund (which you can find on morningstar.com and elsewhere).
As an example, let’s look at the behavior, over four years (2015-2018), of SPDR’s Intermediate-Term Corporate Bond ETF (ticker symbol SPIB). The average effective duration of this ETF on February 15, 2019, according to Morningstar.com, was 4.22 years, though it should be noted that the duration may have been somewhat longer or shorter at the beginning of 2015. When our hypothetical investor purchased this ETF at the beginning of our period, around January 1, 2015, the ETF had a yield over the previous twelve months of 2.65% (this is the amount of annual interest generated divided by the current (January 1, 2015) price), and this is the yield that our investor would have hoped for going forward.
What happened since then? The price of SPIB decreased by 3.34% during those four years (from $34.18 to $33.04), and this is not surprising, given that interest rates were rising during this time. (The Federal Reserve raised its target for the federal funds rate nine times, a total of 2.25%, during those four years. What is perhaps surprising is that the price of SPIB did not drop by more than 3.34%!) But while the price of the ETF fell by $1.14, the investor earned $3.76 in interest during that same time:
2015 $0.90 2016 $0.91 2017 $0.95 2018 $1.00
So the actual total return for this ETF over the four years, accounting for both the slight loss in share price and the interest earned, is 1.94% per year. Although that falls a bit short of the 2.65% that our investor was expecting when she bought the ETF at the beginning, keep in mind that with an average effective duration of 4.22, our investor should have waited closer to four years and three months (4.25 years) in order to “break even” on her expected return. If the price remains stable (the Fed has indicated that it is likely to refrain from additional rate hikes for now), then our investor gets closer to that expected return with every additional monthly interest distribution. And, in fact, just in the first month and a half of 2019, the price has increased by $0.60 and there has been a $0.09 interest payment, both of which will boost the annualized total return.
Bottom Line: Patience
In short, the key to investing in bond funds during a time of rising interest rates is patience. In our example, the investor experienced one step back (a loss in price of $1.14) but also three steps forward (interest of $3.76 and counting). If you hold your bond funds approximately as long as the average duration of the fund, you are likely to realize your initial expected rate of return. And of course the upside of rising interest rates is that one’s interest payments will keep on rising year after year.