Positive Vibes

The probability of a rate hike at the December 16th FOMC meeting, as calculated by the market, now stands at 80%. Whether it actually takes place in a week, or whether the move takes place at one of the next two meetings, the consensus is that short-term rates will move higher soon. We have written over the past months, and even years, not only our view of when the Fed will raise rates, but also what the impact will be on the most rate-sensitive area of most portfolios: bonds.

Just yesterday I received an email that was likely similar to emails you have been receiving lately, from one of the many financial services firms who have taken it upon themselves to save our fixed income portfolios. The subject header read, “Is your fixed income portfolio prepared for rising rates?” The first line, in bold, warned me, “It’s the interest rate risk inherent in fixed income: when interest rates rise, bond values fall.” Based on the severity of warnings such as these, that we have all been subject to through news media outlets and the marketing divisions of asset gathering financial companies, I decided to do some digging to see just how “at risk” we truly are with regard to bonds.

In actuality, my “digging” involved updating a chart to which I like to refer that I think should relieve those concerned about rising interest rates. The chart below, using data compiled by Morningstar’s Ibbotson SBBI 2015 Classic Yearbook, shows that even during long periods of rising interest rates, US intermediate-term government bonds rarely exhibit negative returns: (Click on the chart for a larger version)

Negative Returns Uncommon

While the long explanation for these welcome results is related to duration and convexity (i.e. more is gained from a fall in yield than is lost when interest rates rise), the shorter answer is that total returns from bonds comes from a capital appreciation component and an income component. In a bond portfolio that is properly laddered and/or managed, maturing bonds are reinvested at higher rates, so that over time, higher rates mostly offset capital losses, even during rising rate periods.

An even more positive chart (pun intended) explores what happens to bond returns with longer holding periods. This data, also provided by the Ibbotson SBBI 2015 Classic Yearbook, demonstrates how holding assets for long periods of time has the effect of lowering the risk of experiencing a loss of capital: (Click on the chart for a larger version)

Long-term positive returns

Throughout these 5-year rolling-periods there were times where interest rates undoubtedly rose for an extended length of time. In spite of rising rates, bonds have demonstrated a remarkable ability to preserve capital when held judiciously and through full market cycles.

It should be noted that here at Northwest Investment Counselors we invest primarily in corporate and US Government Agency debt securities. Agency bonds tend to move almost in lockstep with US Treasuries due to their implicit government guarantee, the major difference generally being the structure of agency bonds, many of which are callable, compared with plain vanilla, non-callable Treasuries. The above trends, while similar for all high-quality, investment grade bonds, are likely somewhat different for corporate bonds, with the notable difference being the higher return volatility of corporate bonds. Since they are inherently riskier, the returns in good years will be higher, and the negative return years will see more capital depreciation. Nonetheless, well-researched corporate bonds will offer many of the same portfolio stabilizing characteristics of US intermediate-term government bonds when held for long periods, while in most cases providing a higher level of income.

Please contact us directly to learn more about the contents of your bond portfolio specifically or to hear about our various fixed income solutions that provide income while also matching cash flow with liabilities.