The Sky is Falling! Or at Least Bond Prices Are

It provides a realistic perspective on the role for bonds in a world of rising interest rates.² Please read on… the subject may be arcane to some, but the issues are of critical importance to most investors.

Whaaat? …negative returns!

Bonds have provided such a steady stream of attractive returns since the early 1980s, that investors may be forgiven for not even realizing that they can produce negative returns. And we are not referring to rare instances where the bond issuer goes bankrupt – just plain old negative returns from quality bonds.  For the thirty years ending December 2010, Canadian bonds returns averaged a fabulous 10.3% per year.³ More recently, bond returns have been low, as illustrated in the exhibit below.  Indeed, for the second quarter of 2013, the bond return was minus 2.4%, resulting in a negative 1.3% return for the 12 months ended September 30, 2013.

Looking at the fine print

How can these negative returns happen? It all has to do with the recent increase in interest rates.  After a long period of slowly, but steadily, declining interest rates in Canada, interest rates – also called bond yields – have recently increased.  Bearing in mind that there are actually many bond yields based on the bond’s term (‘maturity’) and levels of credit quality, we simply illustrate the point in the exhibit below for the Canada 10-year bond.  Putting aside the detailed wiggles, Canada 10-year bonds yields have generally declined from near 4% levels in early 2008 to a low of near 1.6% in the summer of 2012.  Since then the yield ranged between 1.6% and 2.0%, until moving smartly higher since early May 2013.

Some explanation is in order.  When interest rates increase, investors with existing fixed-rate bonds still get the same interest payments (‘coupons’) as they did before and the bonds still mature at $100 (‘par’), so there is no change in the future cash flows from these bonds.  In bond parlance, the ‘yield to maturity’ on their existing bonds has not changed. However, as interest rates have increased, investors collectively ‘discount’ the future cash flows from these bonds at a higher discount rate, so today’s market value of these bonds declines.  As the total bond return for the measurement period, say a calendar quarter, is the interest payments plus the change in the price of the bonds over the quarter (even if they are not sold), this can result in a negative return. However, as the cash flows haven’t changed on the existing bonds (that is, no change in the yield to maturity), this means that the timing of the return has been shifted into the future… less return now and more later.

Look on the bright side…

Yes, interest rates are very low and future investment returns from fixed income will be modest.  Nonetheless, with a nod to Monty Python, let’s look on the bright side⁴…

• You don’t actually lose over the full term to maturity.

  This is so, at least barring any badly-timed portfolio trading that locks in the losses – as illustrated above with the yield to maturity concept.

• It’s hard to lose much with quality bonds over shorter time periods.

  Even when measured over shorter time periods, it is very unlikely that an investor will lose much money with bonds. Using U.S. data from 1941 to 1981, which was the last extended period of rising interest rates, the worst one-year bond return for U.S. investors over the 40 years was -5.1%.  The worst 3-year bond return during the 40 years was -0.4% and the worst return over any period of five years or longer was always positive.⁵

• Bonds are insurance in the portfolio.

  More fundamentally, bonds still play their traditional role of insurance against a major equity market downturn.  It is hard to lose much money with bonds, whereas one can lose a great deal with equities. Over the same 1941 to 1981 period in the U.S., the worst one-year return for equity investors was negative 38.9%!  Although rare, it’s also possible to earn negative or very small returns from equities over longer periods of time – even up to 10 years in length.  To be sure, not everyone needs bond insurance.  However, much like house insurance, bond insurance costs something (for bonds with a positive return, the ‘cost’ is the lost potential return from not having that money invested in a higher-return asset). You hope you won’t need it, but it’s good to have all the same.

• Bonds are a portfolio dampener – in the best shock-absorber sense of the word.

  Putting aside the equity armageddon scenario above, having a component of bonds in any portfolio will always serve to narrow the highs and lows in the portfolio.  Investors tend to be their own worst enemy – they are prone to panicking and abandoning equities near the lows of the market.  If bonds effectively serve to ‘soften the ride’ and enable the investor to remain ‘strapped in’ throughout the market cycle, then this is quite possibly the most valuable attribute of bonds overall.

• Here’s hoping for higher interest rates!

  Yes – if interest rates increase, this will reduce periodic returns for bonds, but fundamentally, that’s actually a good thing.  Why is that?  For an investor with a reasonably well structured bond portfolio, as interest rates increase, the investor not only gets the yield to maturity, there’s more!   As the investor receives his coupon payments and as the bonds mature over time, the investor can then reinvest in bonds that are now paying a higher rate of interest, so the investor will actually get better future returns. So far, so good. In addition, rising rates typically signify the global economy is healing and picking up pace.  In turn, this will mean that the equity component of the portfolio should do better and further add to overall portfolio returns. Result… more happiness!

Looking ahead

With substantial economic slack (unemployment and unused industrial capacity) and very low inflation, we don’t expect that interest rates will move substantially higher any time soon. Longer term, given that interest rates are still unusually low and an eventual normalization of the economy should occur, interest rates are likely to trend higher and future returns for fixed income will be modest.

Nonetheless, investing is a marathon, not a sprint. It is not how much the investor earns each quarter that counts.  Rather, it is the investor’s return over the long term. In turn, this necessitates controlling the real risk in the portfolio: permanent impairment from bad investments or doing the wrong thing at the wrong time. The future is inherently uncertain and it is important to position portfolios for ‘what might happen’, not just what we think will happen. Given this, for most investors, bonds are and will remain an important part of the mix.