Q. What should I do with bonds if I am worried about the prospects of rising interest rates in the future?
A. You are not alone and academicians are onto this topic right now. On the Financial Planning magazine website, there is an interesting article discusses investors' fears about the potential for rising interest rates in the coming years, and their adverse impact on bond prices and investments.
Although the end of QE "Infinity" is still unknown, a Wall Street Journal survey of 50 economists predicted the 10-year Treasury will rise nearly 100 basis points to 3.47% by the end of 2014 (with one economist projecting a rate as high as 5.20%). And that would potentially be the second year in-a-row for losses, as given how much rates have risen this year, the Barclays Aggregate Bond index is already down 1.1% year-to-date.
Of course, the reality is that economists are notoriously wrong about their predictions of both the directionality and magnitude of interest rate movements; nonetheless, for those who continue to fear an interest rate increase, what's to be done?
What will happen if rates increase
The author includes an interesting chart showing the impact over the next 10 years of an interest rate increase of anywhere from 1% to 10% in the coming year, from a base rate of a 2.3% yield for the Barclays Agg and the current 5.6-year duration; the forecasted 1% interest would result in a total return loss of about 2.8% next year, but a breakeven by year 2 (given the incoming yield return), and a 3% single-year increase would result in a 13% one-year loss and a breakeven by year 4. Even a 5 percentage point increase - which would be worse than anything in history - would result in a loss of "only" 23.2% in a year, which is painful but still far less than the 37% loss on the total return S&P 500 in 2008 alone, and would recover entirely within 5 years.
Benefits of owning short-term vs. intermediate-term bonds
The author also looks at the relative benefits of owning short-term versus intermediate-term bonds, generally finding that with modest (e.g., 1% - 3%) rate increases, intermediate-term bonds quickly prevail (even with their initial losses), though with severe interest rate changes (e.g., 5%+) it can take 10+ years for intermediate-term bonds to cumulatively outperform the shorter-duration alternative.
The bottom line
The bottom line - for those who fear severe interest rate movements, short-term bonds are better than intermediates, but even for relatively significant rate movements the intermediate bonds don't perform all that badly and recover relatively quickly; either way, both are still far superior to the prospective losses of an equity bear market, though.
A. You are not alone and academicians are onto this topic right now. On the Financial Planning magazine website, there is an interesting article discusses investors' fears about the potential for rising interest rates in the coming years, and their adverse impact on bond prices and investments.
Although the end of QE "Infinity" is still unknown, a Wall Street Journal survey of 50 economists predicted the 10-year Treasury will rise nearly 100 basis points to 3.47% by the end of 2014 (with one economist projecting a rate as high as 5.20%). And that would potentially be the second year in-a-row for losses, as given how much rates have risen this year, the Barclays Aggregate Bond index is already down 1.1% year-to-date.
Of course, the reality is that economists are notoriously wrong about their predictions of both the directionality and magnitude of interest rate movements; nonetheless, for those who continue to fear an interest rate increase, what's to be done?
What will happen if rates increase
The author includes an interesting chart showing the impact over the next 10 years of an interest rate increase of anywhere from 1% to 10% in the coming year, from a base rate of a 2.3% yield for the Barclays Agg and the current 5.6-year duration; the forecasted 1% interest would result in a total return loss of about 2.8% next year, but a breakeven by year 2 (given the incoming yield return), and a 3% single-year increase would result in a 13% one-year loss and a breakeven by year 4. Even a 5 percentage point increase - which would be worse than anything in history - would result in a loss of "only" 23.2% in a year, which is painful but still far less than the 37% loss on the total return S&P 500 in 2008 alone, and would recover entirely within 5 years.
Benefits of owning short-term vs. intermediate-term bonds
The author also looks at the relative benefits of owning short-term versus intermediate-term bonds, generally finding that with modest (e.g., 1% - 3%) rate increases, intermediate-term bonds quickly prevail (even with their initial losses), though with severe interest rate changes (e.g., 5%+) it can take 10+ years for intermediate-term bonds to cumulatively outperform the shorter-duration alternative.
The bottom line
The bottom line - for those who fear severe interest rate movements, short-term bonds are better than intermediates, but even for relatively significant rate movements the intermediate bonds don't perform all that badly and recover relatively quickly; either way, both are still far superior to the prospective losses of an equity bear market, though.
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