Opinion

Felix Salmon

Investing in bonds while rates are rising

By Felix Salmon
June 12, 2013

James Stewart is worried about the bond market, which has plunged in recent weeks:

If there was an index for fixed income with the status of the Dow Jones industrial average or Standard & Poor’s 500 index for stocks, the carnage in fixed-income markets would have been a big story and we’d all be talking about a bear market in bonds…

Mr. Beinner said investors need to reconsider their traditional fixed-income allocations, nearly all of which carry interest rate risk. “It’s an asset class with a negative expected return without any other positive offsetting properties. So why have it as a part of your portfolio?”

Mr Beinner, here, is Jonathan Beinner, the chief investment officer for global fixed income at Goldman Sachs Asset Management — basically, a bond investor. And it’s not common to hear bond investors (or any investors, for that matter) tell you that if you give them your money, your expected return will be negative.

The weird thing, however, is that “the millions of Americans scraping by on paltry interest payments”, as Stewart characterizes them, probably want interest rates to go up. It’s the quandary of the millionaire: if you spend a pretty modest amount each year, you’ll run through your savings far too quickly, thanks to record-low interest rates. If those interest rates were higher, then your income would be higher too.

And it’s not just individuals with savings who are looking for higher rates. According to Jamie Dimon, if rates go up by 3 percentage points, JP Morgan would make an extra $5 billion per year. Stephen Gandel isn’t convinced — but clearly Dimon, who’s sitting on one of the largest fixed-income balance sheets in the world, is pretty sanguine about the prospect of interest rates rising sooner rather than later.

So, should we all be freaking out about the carnage of falling bond prices? Or should we welcome a normalized world of higher interest rates? And given that nearly all investors have some kind of fixed-income exposure, what are they meant to do?

The problem here is that bonds don’t behave like stocks: you can’t hold them in perpetuity, because they mature. And if you try to buy and hold individual bonds, you’ll rapidly discover that keeping track of them all is a lot of work. As a result, just about the only bonds that individuals buy are munis; at least those don’t come with massive tax headaches. (This is one of the main reasons TIPS haven’t taken off in a bigger way: their tax treatment is a nightmare.)

The result is that when people invest in bonds, what they actually do, most of the time, is invest in bond funds. And bond funds, like most funds, tend to do well in good times, while underperforming in bad times. Theoretically, no one ever needs to lose money on any Treasury bond bought at a positive yield — you just hold it to maturity and you’ll end up receiving more than you paid. But if you buy a Treasury bond fund, you can lose a lot of money in a very short amount of time: 6.8% in May alone, according to Morningstar. As Stewart says, that’s “years of interest payments”.

The real problem with today’s low interest rate environment, then, is not that interest rates are bound to go up sooner or later. That’s a good sign: it’s what happens when an economy goes back to normal. Rather, it’s how we get there from here: as Goldman COO Gary Cohn told Stewart, “we have an entire generation of investors who have never experienced a rising rate environment.” Most of those investors are looking after the money of individuals who consider bond funds to be low-risk investments, and a lot of them are going to end up doing very stupid things as interest rates start to rise, losing a lot of their investors’ money.

If you’re invested in a bond fund, then now — just when prices have plunged — is not a particularly auspicious time to sell; doing so just locks in losses. But if your bond funds are falling while your stock funds are rising, then at some point you might start thinking about rebalancing — which would involve selling stocks while buying the very bonds which seem to have entered a secular bear market. That’s going to be a very hard decision to make. Generally speaking, second-guessing rebalancing decisions is a bad idea: the whole point is to set up rules in advance, and then stick to them in a disciplined manner. But when interest rates are rising and bond funds are losing value, pouring even more money into them feels very much like throwing good money after bad — especially when it’s money you can’t afford to lose.

And to make matters even harder, there will certainly be a select group of bond investors out there which makes the right decisions rather than the wrong ones, and which manages to make good returns even in a rising interest-rate environment. It’s not easy, but it can be done. The problem, of course, is that it’s impossible to know ex ante who’s going to be the new bond star. My gut feeling is that it’s going to be someone who remembers 1994, the last time that we had a bear market in bonds.

I might be wrong about picking an old-timer. But what I do know, for people who have blindly put a substantial part of their life savings into bond funds without paying too much attention to exactly who’s managing those funds or what they’re investing in, is that the risk of doing nothing is substantial. The problem, as ever, is that it’s far from clear that doing something is better.

Comments
7 comments so far | RSS Comments RSS

My two thoughts:

#1 if rates go up but the yield curve steepens by 200 basis points that won’t be quite so bad for bond fund holders. A steep yield curve means a bond fund buying 8 year bonds and selling them 3 years later as 5 year bonds gets a nice coupon+ rate of return. In that environment you get something pretty rare… a financial benefit from financial services. Bond fund managers in a steep yield curve are the only fund managers that as a group add value vs a buy and hold strategy. Not rocket science… you buy decent credits you clip coupons and unlike used cars bonds appreciate in value as they age.

#2 It is extremely hard to imagine a set of economic circumstances where the “safest” bonds, western 1st world sovereigns, offer any positive yield over the next 10 years. Look at Japan… they are in a much tougher spot than we are… but 20% currency depreciation in 6 months and they are just getting the printing presses warmed up. Not like they have a choice with 225% debt to GDP and a shrinking workforce.

Posted by y2kurtus | Report as abusive
 

Regarding: “1994, the last time that we had a bear market in bonds.” Part of the problem is that there are so many different kinds of bonds, with different maturities and structures and credit profiles. “The bond market” is a series of markets, at times moving in unison and at times not.

Even in Treasuries, there have been moves since 1994 that have been more dramatic in price than that one.

But all of that is parsing. In broad brush, it has been a bull market in bonds of all types for more than thirty years, so if the test is who has managed through something other than a supportive environment for an extended period, you’re going to have to get some folks out of retirement.

Posted by tombrakke | Report as abusive
 

TIPS are taxed at exactly the same rate as nominals.(Fisher equation) If you are worried about the so called “phantom income” from the inflation adjustment to the principal, buy VAIPX. Problem solved for 0.10%. Hardly a nightmare.

Posted by maynardGkeynes | Report as abusive
 

I would guess that the interest rate risk model isn’t integrated at all with the credit risk models.

Posted by 3underscore | Report as abusive
 

Imagine 2 investors. One buys a 20-bond portfolio, laddered. Another buys the exact same 20 bonds but via a mutual fund conduit. The fund investor is going to pay an advisory fee, but for the sake of argument let’s say the fund’s execution advantage relative to the individual investor (bid-ask spread, etc.)is identical to the expense ratio – although in the muni space that’s seldom the case. Bottom line is that the “advantage” of the ladder over the fund only exists to the extent that the ladder owner doesn’t panic and sell after rate rises while the owners of the mutual fund do panic and sell. Don’t feel too sorry for the owner of Vanguard bond funds; they are going to be just fine relative to people building their own bond ladders.

Posted by solotar | Report as abusive
 

For many types of bonds, bond funds are an absolutely terrible way to invest. If the intended and actual asset quality of the fund is high such as in a treasury or GNMA portfolio you are not benefiting from someone doing credit analysis. Add to that the problem of duration which never comes down. While I think one could make a good case for professional management in say a high yield portfolio, the average person with some financial knowledge could construct a laddered diversified portfolio of actual bonds. In this way you’ve accomplished two things, diversification, and bonds always coming due that can be reinvested at higher yields in a rising rate environment, and if rates come down, you know you have some bonds that will provide that higher return for perhaps as many as 7-10 years.
There is one added benefit, low trading costs since everything is buy to hold, and if you buy in the primary market, you pay the same as everyone else.

Posted by Sechel | Report as abusive
 

@solotar: Suppose other owners of the bond fund do panic, but you stay put. Are you negatively impacted by redemptions regardless? I mean aside from the immediate dip?

Posted by maynardGkeynes | Report as abusive
 

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