Riding the Interest Rate Roller Coaster
It seems as if the moment we’ve all been anxiously awaiting for years may have finally arrived: the era of rising interest rates. The past 15 years have been punctuated by continual asset bubbles — first in the technology sector and later in real estate. Given this infamous recent history, the bond market just seemed to be the latest round in a never-ending boom-bust cycle, one that would end just as badly as the two that preceded it.
The Wild Ride
Our collective fears have suddenly manifested themselves with a quick spike in interest rates. The yield on 10-year Treasury notes has increased by more than one hundred basis points (1.00%) in just the past two months. The price of the Vanguard Total Bond Market ETF (BND) has declined by nearly 4% during that time period, leaving investors with an unsatisfying year-to-date return of -2.60%. Of course, if you have been invested in 30-year Treasury bonds, you’d kill for a -2.60% return right now.
As if on cue, investors have embraced their “fight-or-flight” response, fleeing from fixed-income investments at the first sign of distress. Investors pulled nearly $24 billion out of bond funds and ETFs in June, its worst monthly outflow since the darkest days of the financial crisis in 2008.
The $32 trillion question for jittery bond investors is whether this recent move is just a temporary blip or the start of a long-term rise in rates. If you think it’s obvious that rates have nowhere to go but up, just ask Japanese investors about their experience over the past two decades. Given the violent reaction that markets had to the mere hint that the Federal Reserve may start to wind down their $85 billion monthly bond-purchasing program, you can’t help but wonder if the current bond market is built on a foundation of quick sand.
Hold on Tight
We always stress the importance of staying the course, especially in challenging economic environments, such as this one. But ignoring our innate need to meddle with our portfolios can be particularly difficult when the risk-return profile for bonds seems so skewed in the wrong direction. Although bonds are always advertised as the conservative portion of your portfolio — which they are — they are not immune to price fluctuations. Bonds can and do lose value.
Despite this fact, it’s important not to blow things out of proportion. You certainly can lose money in bonds, but fluctuations in the bond market will typically be much more tepid when compared to stock market corrections. For example, during the rising rate environment from June 30, 1999 to May 16, 2000 — when interest rates increased by nearly 2% — the Vanguard Total Bond Market Index (VBMFX) was down 4.2%. Certainly a little unpleasant, but far from catastrophic. Besides, the yield on your funds will slowly catch up with the rising interest rates as maturing bonds get rolled over into higher-yielding instruments. Indeed, the aforementioned fund returned a solid 6.5% during the 12-month period starting May 16, 2000. Stay the course.
A Cure for the Motion Sickness
If the thought of a several-percent increase in interest rates and the concomitant price declines makes your stomach churn, there are options available to help you sleep peacefully at night. For instance, you could move your money into short-term bond funds or ETFs, which are less sensitive to interest rate changes. As an alternative to such funds, you could just buy Treasury bonds directly and hold them to maturity. In addition, you could move the fixed-income portion of your portfolio to CDs or savings bonds. Of course, the best option might just be to put down the Wall Street Journal and spend a fun day in the park.
But should we really just sit idly by if interest rates skyrocket to the stratosphere? In times like these, it can be smart to recall the wisdom of the Hippocratic Oath, namely, “First, do no harm.” We are terrible at predicting the future, especially when it comes to complex phenomenon like financial markets. This is why we diversify your portfolio across many different assets. When we attempt to outsmart the market, we often just outsmart ourselves.
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