It Won’t Hurt That Much!

Bond prices dropped sharply on Tuesday (meaning interest rates increased), so I decided to write a quick note about an interesting Vanguard article that I read last week.  The Vanguard piece is actually a few years old and titled, “Risk of Loss: Should Investors Shift From Bonds Because of the Prospect of Rising Rates?”  Here’s the link.

The premise of their article was that whether or not the bond market is experiencing a “bubble”, you should stay the course.  While this may not be a surprising argument from a mutual fund family, I thought that they made some interesting points (that I’ll describe below).  (I tend to be a fan of Vanguard, so you can take my comments, as always, with a grain of salt.)

I’ll preface this summary with a key thought.  Several well-known investors have recently commented that it’s unlikely that anyone will look back ten years from now and say, “I wish I had put all my money in ten-year Treasuries yielding 2%.”  I agree – and this summary isn’t an argument to throw money into bonds.  Rather, I thought that Vanguard made an interesting argument that even if we’re in a bond bubble, the ramifications will be very different than when a stock bubble bursts.

Finally, realize that this Vanguard article was written when the Barclay’s Aggregate Bond Index was yielding 2.90%.  Last week, the index was yielding closer to 1.90%.

Here are some of their ideas:

1. Huge increases in bond yields are very uncommon.  (Another way of saying this is that huge drops in bond prices are very uncommon.  Prices and yields move inversely).  Imagine that the yield on the bond index moved from 2.9% to 6.9%.  This would be a tremendous move.  This type of move has only happened (within a year) twice before (1980 and 1981).  On a relative basis, a 140% increase in rates has never happened (in one year) in the U.S.  (Of course, you would have to believe that there’s a greater possibility of a 140% move when rates are low.)

2. If we did have a 400 basis point increase in rates (from 2.9% to 6.9%), losses would be significant.  The one-year price decline (~13.5%) would be the worst year ever.  The previous worst 12-month return was -9.2% (March 31, 1980).

3. After that one bad year, you’d (hopefully) be earning higher returns again (if rates didn’t keep rising).  After you suffered through that 13.5% loss, you would earn 6.9% per year going forward.  By the end of year three (one year of losses and two years of gains), you’d be close to even.  In other words, your losses would be offset by higher yields in the future.  See Vanguard’s slide below.

4. You shouldn’t lose sight of the reason that you hold bonds – to diversify your portfolio.

5. A bond “bear market” is different than a bear market in stocks.  With stocks, we think of a bear market as one in which prices drop 20%.  We’ve never had that kind of drop in the bond market index.  With bond markets, we tend to think of a bear market as one in which returns are negative.

6.  The worst bond losses can’t be compared to the worst stock losses.  The worst 12-month drop in bonds was 9.2%.  This pales in comparison to losing 67.6% in stocks (for the year ending June 1932).

7. Calendar year losses in bonds have been relatively rare and small.  We’ve never had huge losses in bonds when viewing them on a “calendar year” basis.  The worst calendar year drop for bonds was 2.9% (1994).  That was followed by an 18.5% gain in 1995.  To put that 2.9% loss in perspective (for bonds in 1994), realize that stocks lost 2.9% (or more) on 27 different trading days in 2008!

8. Inflation would make losses worse.  All of the returns that are mentioned above are in nominal terms.  If you have losses plus inflation, your real returns are (obviously) worse.

9. Reasons for bond losses.  Higher interest rates are normally caused by either inflation, government budget problems or some systemic shock.

10. Bond losses could cause other problems.  Vanguard didn’t address the problems that could be caused by bond losses (such as the hit to bank capital due to losses in their bond portfolio or the increased cost of interest on government debt).

Talk to you sometime in the future…

Have a great week.

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