Must Bond Investors Fear Rising Interest Rates?

[RandyAdams1978]

I found this on the web and then searched bogleheads.org to see if anyone had previously posted it. My searches returned no relevant results, neither for the title, a portion of the title, or the author. I apologize if this has been pored over before:

http://advisorperspectives.com/newsletters12/pdfs/Must_Bond_Investors_Fear_Rising_Interest_Rates.pdf

Must Bond Investors Fear Rising Interest Rates?
Andrew D. Martin
January 24, 2012

In it, the author attempts to sooth worried investors about the future of bond funds. Among other points, he is attempting to refute this article:

http://www.investmentnews.com/article/20110914/FREE/110919976

He attempts this by, in part, looking at historical returns for the few bond funds that existed more than 30 years ago.

I have a question (or maybe better put, a misunderstanding) that perhaps this forum can address. Near the bottom of the article, a number of caveats are brought up. One mentions a devastating scenario in the doomsday article:

That article asserted that, if yields on Treasury Bonds rise just 3%,
10-Year Treasurys will decline 23.5% and 30-Year Treasurys will drop 40.7%. The
problem with this is rates would have to rise 3% in one year. Rates have never come
anywhere close to rising 3% in one year – 3% is not “puny.”

Question #1a: In the above, he seems to be interchanging the terms yield and rates. Is that proper?
Question #1b: Is that true?

Then I looked up the article that caused the broohaha in the first place. The quote is accurate. But the article goes on to say:

Inker and GMO are well-known for their seven-year projections for asset classes, which have been very accurate. "Our expected return is that the 10-year Treasury note loses 1.3 percent a year after inflation," says Inker.

Question #2: My takeaway here is that, yes, rising rates are bad for bonds, but these guys don't think that the devastion scenario is going to play out. Am I reading this right?

Question #3: Seems to me that one article is talking about bonds while the other is talking about bond funds. Different animals, right?

I'm hoping the helpful folks here can clear up my confusion.

[johnep]

It appears the author is using nominal rates in his example. For example, he shows $10,000 in 1963 growing to $15,429 in 1981 in nominal terms and claims this as a gain. From a nominal perspective he is correct. However, $15,429 in 1981 is equivalent to $5,194 in 1963 in real terms. I would argue that is a substantial loss, a loss of $4,806 (48%) of original $10,000 investment. We had extremely high inflation during that timeframe, including several years of inflation greater than 10%. Long term investments need to be looked at in real terms, which puts a totally different light on his example. Inflation has averaged about 2.5% the past 20 years, but historically has averaged around 3.5% (I am not positive of number but I know it is higher than 3%).

To some extent, I agree with his premise that the bond bubble is overblown but at some point rates will go up and when that occurs bond funds will sustain losses. No one knows when that will come. It may not come for several years. I have a diversified bond portfolio with an average duration of 4 years and mostly investment grade. I feel the gains I have had the past 2 or 3 years will offset my losses whenever interest rates do go up.

[bertilak]

Here is a nice concise discussion about bonds and rising interest rates: http://www.obliviousinvestor.com/what-h ... tes-go-up/

There are several factors to consider and they are spelled out in the above.

[john94549]

When the NAV of a bond fund drops enough in a relatively short period to get your attention, I suspect FDR's words come into play. That said, if you're beyond fearing fear itself, I suspect you could spend a week or so reading all the threads on bonds, bond funds, and rising interest rates. Many Bogleheads prefer the simplicity of bond funds, are in them for the "long haul", and accept poor returns over some period of time as a "cost of doing business." Others prefer the predictability of CD ladders for part of their fixed-income, or IBonds. What one selects is of less import, in my opinion, than selection itself. Stated another way, it is more important to have a rational allocation to fixed-income as part of your AA than the "optimum" fixed-income product at any given point in time, for some arbitrary time period.

If, after reading all those threads (noted above), you wish to "fine tune", you will receive no shortage of opinions on how to do so.

[YDNAL]

I found this on the web and then searched bogleheads.org to see if anyone had previously posted it. My searches returned no relevant results, neither for the title, a portion of the title, or the author. I apologize if this has been pored over before:...

In your search, did you come across Bogleheads Wiki - of special interest a section on Bond Duration?
http://www.bogleheads.org/wiki/Bonds:_Advanced_Topics

Here's a recap.

Duration has another useful summary property, which is that if the yield curve shifts in parallel then duration is the point of indifference to interest rate changes. For example, if a bond/portfolio/fund with a duration of 5 years experiences a market interest rate increase of 1%, its value will drop by approximately 5%; however, since the same coupon payment now represents a higher percentage of the bond's value, its yield is higher (it will match the market rate), and the higher yield plus higher market interest on coupon payments compensate for the NAV loss.

[dbr]

It appears the author is using nominal rates in his example. For example, he shows $10,000 in 1963 growing to $15,429 in 1981 in nominal terms and claims this as a gain. From a nominal perspective he is correct. However, $15,429 in 1981 is equivalent to $5,194 in 1963 in real terms. I would argue that is a substantial loss, a loss of $4,806 (48%) of original $10,000 investment. We had extremely high inflation during that timeframe, including several years of inflation greater than 10%. Long term investments need to be looked at in real terms, which puts a totally different light on his example. Inflation has averaged about 2.5% the past 20 years, but historically has averaged around 3.5% (I am not positive of number but I know it is higher than 3%).

This is a good point. However, one should think of this as inflation risk rather than interest rate risk. The difference is important because over long times interest rate risks will tend to be balanced both positive and negative but in our economy inflation is almost always positive and sometimes large. Far and away the greatest risk to the long term bond holder is inflation rather than interest rate fluctuations. That is one of the reasons it can be prudent to buy TIPS for the long haul. One should take the advice to look in real terms and recognize a different risk, which is the risk that one is invested at too low a return to meet one's objectives. This must be done in real terms as objectives must be measured in the use of money rather than in the fact of having money.

[LadyGeek]

This thread is now in the Investing - Theory, News & General forum (general investing question).

[tfb]

That article asserted that, if yields on Treasury Bonds rise just 3%,
10-Year Treasurys will decline 23.5% and 30-Year Treasurys will drop 40.7%. The
problem with this is rates would have to rise 3% in one year. Rates have never come
anywhere close to rising 3% in one year – 3% is not “puny.”

Whether it's rising 3% in one year or 1% a year over 3 years doesn't matter much in the grand scheme. If it's 3% in one year, you have a bigger hole and you slowly climb out of it. If it's 1% a year over 3 years, you drop into a shallower hole every year for three years. Declining 23.5% in one year is bad. Declining 7% a year three years in a row is not much better.