Over the last year or two, I have seen a number of articles in the financial press suggesting bonds are a lousy investment.  When you really get into it, the main argument put forth is that “interest rates are as low as they can go, and since bonds do badly when interest rates go up, they must be a lousy investment.”  Aside from the obvious point, that interest rates aren’t as low as they can go, and the fact that they may stay quite low for a long, long time, there seems to be a real misunderstanding of the concept of interest rate risk.

WCICon18

[Update April 2015: That first paragraph now seems prophetic, doesn’t it? From 2011-2014 the Vanguard Total Bond Market Fund had returns of 8%, 4%, -2%, and 6% and is up YTD in 2015 as well.]

Interest Rate Risk

Interest rate risk is the risk you take when you buy bonds with a longer maturity, such as a 20 or 30-year treasury bond.  As interest rates rise, bonds go down in value.  Who wants an old bond with a coupon of 5% when you can get a new one with a coupon of 6%?  So, therefore, the price of the old bond must drop until it has the same yield as a new bond-6%.  Likewise, as interest rates fall, bonds go up in value.  The best way to measure interest rate risk is with duration.  Duration is calculated using a somewhat complicated formula, but once you know the duration, it is an easy concept to understand and use.  If the duration of a bond or the average duration of a bond fund is 5 years, then if interest rates go up 1%, the bond will lose 5% of its value.  If interest rates go down 2%, then the bond will gain 10% in value.  Part of the reason bonds have done so well over the last two decades is the tailwind of falling interest rates they have been riding.  So now, the gurus say, interest rates “have to” go up, and thus bonds will be fighting a headwind for some time.  Meanwhile, unsophisticated investors freak out and get out of bonds altogether because they are worried about the bond market tanking.  They simply don’t understand the magnitude of the risk.  So what is the magnitude of that risk?

Pray for Rising Rates

Well, the first thing to understand is that the fed doesn’t set all interest rates.  It sets only the very short-term interest rates.  All other interest rates (intermediate term, long term etc) are set by the market.  So just because the fed raises rates doesn’t mean your bond or bond fund will be affected at all.  The second thing to understand is that rising interest rates are GOOD for the long-term investor.  Just like a young investor beginning his investing journey should “get down on his knees and pray for a bear market”, so should a bond investor, especially an accumulating one, pray for higher interest rates.  Not necessarily the inflation that often precedes the rising rates, but the rising rates.  The reason why can be shown with this example.

Consider an investor who owns the Vanguard Intermediate-Term Bond Index Fund.  The fund currently yields 3.3%.  Since it holds only high-quality bonds, this is the best estimate of its future return-3.3% per year.  The duration of the fund is 6.3 years.  So if intermediate-term interest rates rise 1%, the fund will lose about 6.3% of its value.  So let’s say interest rates rise 3%.  How long will it take before the investor is better off with the higher rates?  Let’s assume the investor starts out with $50,000 in this fund and adds $10,000 a year to it.

Value Of Investment
Year No Change In Rates 3% Rise In Rates
0 50000 40550
1 61650 53105
2 73684 66450
3 86116 80637
4 98958 95717
5 112224 111747
6 125927 128787

 

By the end of year six, the investor is clearly better off with the higher rates (assuming no accompanying high inflation.)  It is relatively easy to decide how much interest rate risk to assume.

How Much Additional Yield is Enough to Compensate for Interest Rate Risk?

Let’s compare the three term-specific Vanguard bond index funds: short-term, intermediate-term, and long-term:

Fund Yield Duration Years For Accumulator To Break Even
Short-Term 1.20% 2.7 Years 2 1/2 years
Intermediate-Term 3.30% 6.3 Years 5 1/2 years
Long-Term 5.10% 13.1 Years 9 1/2 years

 

So if under a rather drastic scenario (rapid 3% rise in interest rates affecting the fund), it takes just a few years to break even, you need to ask yourself whether is it worth the lower yields to stay in short-term bonds (or even worse, money market funds yielding 0.1%.)  How much additional yield is adequate compensation for running interest rate risk?  Only you can answer this question, but experts such as William Bernstein and Larry Swedroe generally recommend keeping bond maturity (and thus duration) short (1-5 years) and then taking additional risk on the equity (stock) side of the portfolio. With current yields and durations, we see that we get about 0.58% yield for every additional year of duration we take on moving from short-term to intermediate-term.  That seems like pretty good compensation to me.  On the other hand, moving from intermediate-term to long-term, we only get 0.26% yield for each additional year of duration.  That doesn’t seem nearly as wise a risk to run.

The risks we are discussing, of course, pale in comparison to the equity risks that the unsophisticated investor apparently has no trouble running despite his fear of the rather minor risks of the bond market.  You don’t have to have been investing very long to remember watching the stock market fall 48% with no promise of recovery over just a few short months in the last bear market.  Riskier segments of the market fell even further.  (The total drop for REITs was about 75%.)

Bottom Line on Bonds

Don’t abandon your bonds.  They provide a very important counterweight to the stocks in your portfolio.  Intermediate-term rates are unlikely to rise dramatically AND quickly, and if they do, it won’t take that long to make up for it.  If you’re really uncomfortable with interest rate risk, hedge your bets by shortening your maturity slightly.

 

Fund Yield Duration Years To Break Even
Short-Term 1.20% 2.7 Years 2 1/2 years
Intermediate-Term 3.30% 6.3 Years 5 1/2 years
Long-Term 5.10% 13.1 Years 9 1/2 years