BondsOnline Advisor

Bonds, Rising Rates and Diversification

by Stephen Taub

What happens to the value of bonds if interest rates rise? Will rate hikes result in large losses in the overall portfolio?

These are perhaps the biggest questions weighing on the minds of all fixed-income investors.
And, although avoiding bonds would be the instinctive reaction to rising rates, it would be a bad strategy, especially if you use bonds as part of an overall diversification plan.

This is because as an asset class, bonds historically have been much less volatile than stocks. Fidelity Investments points out that since 1926, intermediate government bonds have had less than one-fifth the volatility of large-cap stocks, with fewer extremes in performance.
For example, the worst calendar year performance for intermediate government bonds was a negative 5.1% in 1994. This compares with a 43.3% collapse in large cap stocks during their worst calendar year in 1931.

On the other hand, the best year for intermediate government bonds was 1982, when they surged 29.1%, while the best calendar year performance for large-cap stocks was 54% back in 1933.
Bonds can also help reduce the overall volatility of a portfolio because they generally have a low correlation to stock returns. Sometimes the correlation is even negative.

For example, as we were reminded for the past few years, when the economy is lousy, stocks generally sag while investment-grade bonds perform pretty well. The opposite is generally true when the economy is very strong.

What?s more, bonds can lower the overall volatility of a portfolio.

For example, since 1926, a portfolio with a 70/30 stock/bond mix captured 91% of stock returns, but with only 70% of the risk, as measured by standard deviation, according to Fidelity.
Over the same period, a 60/40 mix captured 87% of stock returns with only 60% of the risk.

And since the stock market bubble burst in 2000, investors have suddenly decided that managing risk is very important. In fact, Fidelity points out that according to a 2003 study by Roper ASW, a record 60% of respondents reported a high aversion to risk, which is the most conservative reading in the 26-year history of the study.

Still not convinced that fixed-income is an important part of a portfolio even in a rising interest rate environment? Then, let?s look at some historic, worst-case scenarios. Take, for example, the 10-year periods for bonds that ended in December 1981, which does not evoke great memories since it encompassed the high inflation 1970s, when interest rates soared from 5.3% to 14%.

Bond investors took a beating back then, especially compared with stocks, right? Not exactly.

Turns out that investors with 80/20, 70/30, or 60/40 mixes between stocks and bonds gave up very little total return as they reduced risk, according to Fidelity?s calculations. In fact, the investor with 30% in fixed income investments captured 98% of the total return of stocks with only 73% of the risk.

Why? Because the 1973-'74 period was also one of the worst stock bear markets ever.

There was also low correlation between the two asset classes. And, because rates had risen so much, bond investors received a big chunk of their return from higher yields, offsetting the price erosion.

Now, let?s look at another period of rising interest rates--from 1962 to 1969--when yields on intermediate government bonds made its way up from 3.5% to 8.3%. During this period, the 70/30 mix captured 78% of the total return of stocks with only 62% of the risk, according to Fidelity?s calculations.

Not a bad tradeoff, right?

In fact, a study by David A. Levine in The Journal of Portfolio Management in 1996, and another analysis by Sanford C. Bernstein & Co. based on Levine?s study concluded that the gain from the higher interest payments exceeded the capital loss.

?The fact is, when interest rates rise, the income increases, so long as the portfolio is actively managed,? Bernstein explains. ?This enables new, higher-interest bonds to be brought into the portfolio, and the resulting benefit is more income. Understanding this dynamic is key to successful bond investing.?
 

Stephen Taub is Contributing Editor to BondsOnline. Stephen has been covering financial markets for more than 20 years with Financial World magazine, Individual Investor.com, CFO.com, and others.