Why bond funds can be toxic for your portfolio

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Because bonds do well when interest rates go down, thirty years of rate declines have convinced many that bonds are instruments that can reasonably be considered “safe.”  Indeed, a “conservative” portfolio has come to be synonymous with one that is heavy on bonds. But a rising interest rate cycle seems to be taking hold, and bond investors are now exposed to unfamiliar risks by holding on to “conservative” portfolios. If interest rates go up, those portfolios will not provide the safety that investors seek.

Interest rates have long cycles. They rose from 1898 through 1920, dropped from 1920 through 1940, climbed again to historic highs from 1940 to 1981 and then plunged to historic lows from 1981 through 2012. For the last 125 years, it seems, interest rates have settled in cycles that last decades. And a new one may have started about a year ago, when the US Treasury 10-year note rate plummeted to about 1.50%, a record low and even below the likely rate of inflation over the next 10 years. Barring deflation, those levels will not be around again for a long time.

Graph: Interest rates move in long cycles

Investors who hold individual bonds are only marginally affected when interest rates go up as long as they keep those bonds to maturity. A fixed-rate bond is simply a promise someone made to repay a borrowed amount (“principal”) at maturity and pay periodic interest (“coupons”) on that principal along the way. That commitment is fixed regardless of whether interest rates go up or down. Unless the borrower defaults, the scheduled payments remain the same.

When interest rates go up, however, the price of a bond that has time left before maturity goes down. This is often confusing to investors, but a simple analogy with stocks may help understand why this is so.

The dividend yield of a stock is simply the dividend divided by the stock price. If the dividend remains constant, a lower stock price results in a higher dividend yield. So is with bonds that pay a fixed coupon: a lower bond price results in a higher bond rate, or, identically, if the market is demanding a higher rate for an existing bond, the price of that bond will have to go down.

It follows that there is a big difference between an investor who keeps an individual bond until maturity and one who doesn’t. While the former will get all the payments as promised regardless of whether interest rates go up, the second one will not because he or she will sell the bond at a lower price.

This, in a nutshell, is the inherent problem with bond funds. Bond fund managers almost never hold bonds to maturity. This is because bond funds are typically defined by maturity targets (short-term, intermediate-term, and so on) and as time goes by, holdings are rebalanced to keep the fund's average maturity constant. To do so, managers replace shorter ones with longer ones constantly, booking losses if interest rates go up because they sell bonds that were acquired at higher prices, when interest rates were lower. They buy high and sell low. Thus bond funds do not have the certainty of payments that comes from holding a bond to maturity.

This is not a theoretical problem. Bond fund returns strongly mirror changes in interest rates. The graph below shows how much this is true for a long-term-bond fund from Vanguard (VBLTX). Every year that interest rates decline, the fund’s returns go up, and vice versa. A multi-year string of interest rate increases will cause this fund to perform quite poorly. And, as we saw, interest rates tend to head in a single direction for many years before they change course.

Graph: Bond fund returns move opposite to interest rate changes

We estimated the return of a hypothetical intermediate-maturity bond fund for the last 110 years or so using interest rate data provided by Prof. Robert Shiller at Yale University. We assumed that an investor would hold a 10-year US Treasury bond for a year and then replace it with a new one at the then-prevalent rate. We then calculated the average yearly return of that bond “fund” over the next 10 years. The results are in the graph below.

Graph: Today's rates are a strong indication of bond fund returns in the future

Not surprisingly, 1980 was the best time to buy this hypothetical bond fund. Not only rates – and therefore coupon payments – were very high in 1980 (close to 14%) but also bond prices went up in the following years as rates came back to earth. Anyone who would have bought this hypothetical bond fund in 1980 would have reaped close to 18% average annual returns from 1980 through 1990 due to a combination of high coupon payments and strong price appreciation.

Conversely, one of the worse times to buy this fund would have been 1940, at the bottom of the interest rate cycle. Ten years later, the average annual return would have been just above a paltry 2%. It could have been far worse if rates had not stayed fairly low for the next ten years. If they had gone up higher sooner, this bond fund would have suffered accordingly.

This tells us that the level of interest rates today is a strong forecast of what the return of a bond fund is likely to be over the next ten years. Investors should ignore the high returns of the last 30 years and instead look ahead and think what is likely to happen to bond funds if a new interest rate cycle has started. In our view, it is almost assured that bond funds will have far lower returns than at any point in the last few decades.

How bad it will be for bond funds will depend on how fast interest rates go up. If, as some argue, interest rates hover around low levels for a few years, then the damage might be limited, with returns low but hopefully not negative. If interest rates go up quickly, however, the result could be much worse.

In fact, results from three of the largest bond funds in the world show how terrible things can be for “conservative” funds in this new environment.

Year-to-date, PIMCO’s Total Return fund is down close to 4.5%, DoubleLine’s Total Return is down almost 2%, and Templeton’s Global is down well over 2%. Their respective portfolio managers – with over $200bn under management in just these three bond funds – are hard at work trying to convince their clients that this dismal performance is an aberration. Looking at history, however, it seems that poor bond fund performance is almost inevitable. To protect their hard-earned money, investors will have to find new safe harbors. This is something that bond funds, alas, can no longer claim to be.

What now?

We use quantitative measures to build and maintain dynamical multi-asset portfolios for our clients, which can offer a clear solution to traditionally built portfolios that often contain substantial portions allocated to bond funds. Our process aims to identify when to buy or sell different asset classes, with a focus on avoiding extended losses, seeing through the haze of very short-term volatility, and looking to invest in individual bonds when the time is appropriate. Please send us a request for a copy of a whitepaper describing our investment process, or contact us if you would like to know more about how Path Financial’s investment processes works. We’ll be happy to set up a confidential meeting to discuss new paths to financial success. Read more