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.
[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 |
So far I really enjoy your blog. However, with 0 financial background, your explanation of why bonds lose value when interest rates rise was still a bit over my head. Nonetheless, the overall message was helpful. I’ll be starting med school soon and look forward to reading more posts.
Bonds lose value when interest rates rise becuse the interest rate offered by the bond becomes lower than the interest rate offered by the banks. Obviously in this circumstance the Investor will choose the higher interest offered by the bank and not the bond. Like a competition between the interest rates offered by the banks and the bonds. Bonds will compete with the rates offerd by the banks to appeal to investors.
Glad you’re enjoying it. Basically, when rates rise, you can buy a brand new bond with a higher yield so your old bond with the lower yield is now worth less. The opposite happens when rates fall.
Thank you for the feedback. I’m obviously new at this so I’ll try to explain a little better.
Bonds are a loan. They have a coupon rate, say, 5%. If it is a 10 year bond, it pays you 5% a year for 10 years and then you get your principle back. So you buy it because it sounds like a pretty good investment. A couple weeks later rates go up and now you can buy a 6% bond. Let’s say you want to sell your old 5% bond now. Why would anyone pay full price for your crappy old 5% bond when they can buy a brand new shiny 6% bond? Answer: They won’t, at least not at full price. But they’ll buy it at a sufficient discount. So the value of your bond went down. Rates go up, value of bonds goes down. Rates go down, value of bonds goes up. Quite simple once you think it through.
Good luck with your career and investing.
Thanks, but sorry I still don’t understand how the bond loses value. I understand that, if interest rates rise, the bond isn’t as good of a deal as new bonds with a better rate. However, this still doesn’t seem to imply that the bond loses value. It’s not as good as the newer bonds, but doesn’t the value stay the same? It makes sense you would have to assess whether or not it’s better to sell the bond at a discounted rate if interest rates rise or just keep it, but it doesn’t make sense to me that the bond has lost value.
Anything is only worth what you can sell it to someone else for. Since it is worth less to someone else because it pays a lower interest rate, it’s value is less.
Now, one nice thing about holding individual bonds vs a bond fund is that it will eventually recover its value, at least nominally. That is, when it matures, you get all your principle back. So in a sense, the bond recovers its value. But while you wait for that, you’re earning less on it than you could be, so it is still worth less than a newer bond paying more.
This is an important concept to understand, and not entirely intuitive.
I like your post, though I think you should also address the inflation risk in this post to show what your risk weighted rate of return would be.
With interest rates so low and inflation rates in the 1-1.6% area (with a Fed goal of 2% and the likelihood they will overshoot as they are very willing to do), I think that significantly changes the bond returns for the next few years. You are taking significant, perhaps almost equity sized, risks without the potential for being paid for that risk.
My feeling is that bonds probably should be a much smaller portion of portfolios for the next few years while we see if the central banks can normalize rates and clear their balance sheets. As a matter of fact, I’m not sure cash isn’t a bit safer than bonds at least for 2015 and 2016 since I doubt we’ll get much inflation over 2%, so there is a pretty well understood and relatively fixed downside as the bond prices fall and interest rates rise. And you will have the potential to take advantage of any significant market decline.
Just found your web site and really enjoy it.
Funny you would say that. That’s what everyone was saying in 2011 when this post was written. It’s been wrong for at least 4 years. Calculate out your interest rate risk. I bet you’ll find it to be nowhere near “equity sized.” If your duration is 5, and intermediate (not short term) rates rise 2% relatively rapidly, you’re looking at a 10% loss, which would be made up in 5 years at the higher rate. That’s nothing like equity risk. Yes, I understand inflation and not reaching your goals because of it is your most significant risk, but the risk of not being able to tolerate portfolio losses and selling out is hardly insignificant. Bonds help a lot more with the second than the first.
I ran some different scenarios on excel, and I agree with you that the interest rate risk of investing in short and intermediate bond funds is relatively small. However, investing in long term bond funds, especially if someone is near retirement, seems like a ticking time bomb.
Let’s say you are just about to enter retirement so you decide to invest $1000 into a long term bond index fund. For the sake of simplicity, this fund only invests in 30 year US treasury bonds. What is the growth of your $1000 investment if interest rates increase from 3% to 8% over the next 2 years and remain stable at 8%?
Even if you reinvested the dividends from the bond fund at the new 8% interest rate, your initially $1000 investment will only be worth $506 after 2 years. A 50% loss in 2 years? Sounds pretty risky to me! Many new retirees may be shocked to see such losses in bonds and the risk of selling out their investment may be quite high.
However, the story doesn’t stop there. If interest rates stay at 8%, It would take over 11 years to break even. What happens when you account for inflation? Well, assuming 2.5% annual inflation, it would take over 18 years for your investment to break even in terms of real purchasing power. Considering the US stock market has made a positive real return in every rolling 15 year period for over the last 100 years, one could even argue that the risk of investing in long term bond funds is even greater than investing in equities.
Some may argue that a scenario where interest rates increase from 3% to 8% over a period of 2 years and remain stable at 8% is unrealistic. I would agree that this would be very unlikely, however, I do not believe that it would be impossible. Current interest rates on US treasuries are some of the lowest since our country was founded over 200 years ago. There is nowhere to go but up. Also, there have been times in our recent history when 30 year US treasury rates have increased by a significant amount in a short period of time (it increased from 9 to 15% between 1980-81 and hovered around 8% for about 15 years).
Here is the math (please let me know if there are any errors):
https://www.dropbox.com/s/ufsq11nh3r0evkf/Long%20term%20bond%20fund%20scenario.xlsx?dl=0
I disagree that there is nowhere to go but up. People have been saying that for nearly a decade now while rates have continued down down down until recently. At any rate, I agree you shouldn’t invest in 30 year treasuries due to interest rate risk. Half my bonds have a duration of four days and the other half has a duration of 7.8 years. My hard money loans have an average maturity of something like 6 months. I have no debt. I’m all for higher rates as long as they aren’t accompanied by higher inflation or recession. It would not take very long for me to make up for my losses with the higher interest rates.
comment 2
qwerty
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great points! i also know many people that think stocks are less risky than bonds these days, because of low interest rates.
Thank you for this eye opening post!
I had a question regarding your “Years For Accumulator To Break Even” chart for short-, intermediate-, and long-term bonds. What would the numbers look like if you adjusted for inflation?
Though it would take 13.1 Years in your example to nominally “break even” in a rising interest rate environment if you owned long term bonds, over this period of time, it seems to me that your purchasing power would decrease by almost 30% (given historical 2.5% rate of inflation).
A 30% loss in real purchasing power over a period of 13 years? Sounds pretty risky to me, especially if you’re nearing retirement. Has there ever been a loss this great over a period of 13 years in the stock market in terms of real purchasing power (when you take into account reinvesting dividends)?
Some may argue that there is a negative correlation between inflation and rising interest rates. However, haven’t there been times in history when we have seen both inflation and rising interest rates? Thanks!
Inflation affects stocks and bonds both so I ignored it. But yes, inflation is a major issue for any investor and yes there are times when inflation rises and interest rates rise.