Bond Prices May Drop If Rates Rise, But How Bad Could It Get?

2013 April 1
by Kyle Bumpus
from → Investing And Investments

Current conventional wisdom holds that interest rates are at unsustainably low levels and have nowhere to go but up. Neverminding the fact that people have been saying this for several years now, they have a point: interest rates are very low and they probably will rise in the next few years, although that’s by no means guaranteed (for instance, if the economy slips into recession again, rates will probably remain low). But so what if they do?

Assume Interest Rates Rise: Then What?

Let’s assume for a moment that interest rates must rise. Then what? Since bond prices covary inversely with changes in interest rates, bond prices will fall if rates rise. It’s unavoidable. But is that really a big deal? Well, that depends on what kinds of bonds you own!

The Worst-Case Scenario For Bonds Isn’t That Bad

The arithmetic of bonds works out this way: for every 1% change in interest rates, a bond fund’s nav will move by the amount of its effective duration in the opposite direction. For example, a bond fund with an effective duration of 5 years will drop 5% in value for every 1% increase in interest rates. So if interest rates are currently 1%, a bond fund with a 5 year effective duration would drop by 15% were interest rates to increase from 1% to a more historically-normal 4%.

Sound bad? It’s really not. For starters, the moment rates start going up your fund will begin reinvesting the proceeds from maturing issues at higher rates. Instead of paying just 1%, the fund’s yield will rapidly increase, given you a yield cushion of an extra 3% per year. Thus, over a 3 or 4 year period, you’re looking at maximum losses in the 5-6% range. Hardly ideal, but it’s not going to cause you to start eating dog food in retirement, either.

Of course, that’s just the worst-case scenario for the total bond market (which happens to have an average duration of right around 5 years). Investors in long-term bond funds, with durations ranging anywhere from 8 years up to 20+ years, could be in for a much rougher ride. On the longer side of the maturity spectrum, investors in long-term bonds could be in for losses of 15-20% or more over a 3 or 4 year period if rates rise dramatically. Investors who have shifted their bond allocation to ever longer-maturing bonds in search of extra income could get hurt, which is one of the reasons I advise people to never reach for yield: the extra risk just isn’t worth it, in many cases.

What Are The Alternatives, Anyway?

Now that we know what the worst-case scenario for most bond investors is, and that it’s not that bad, I pose the following question to the bond-bubble rabble rousers: if not bonds, then what? After all, you’ve got to invest in something unless you think putting your money under the mattress is an acceptable investment. Let’s look at how the alternatives might fare in a rising interest rate environment.

Stocks

Rising interest rates usually  mean one of two thing:

  1. Rising inflation
  2. A booming economy

Clearly, stocks are a great place to be when the economy is booming. If you think the economy is about to take off, it might be rational to dump bonds in favor of stocks (but only if you know something the market doesn’t!). If runaway inflation is the reason rates are heading up, though, moving into stocks will likely be disastrous because, while stocks act as decent hedges against inflation over the long run, they don’t do very well at all when inflation spikes in the short term.

So as you contemplate moving out of bonds, think about which scenario seems more likely: inflation or an economic boom. I think even the most optimistic prognosticator would have a hard time predicting an economic boom. In light of our economy’s lingering systemic issues, I think the most likely scenario is a decade of moderate, not great, economic growth with perhaps a few major bumps along the way. The bond bull market may be over, but equities aren’t exactly primed for a monster bull run. Yet.

Real Estate

The real estate recovery seems to have finally begun in earnest. I don’t see a return to pre-bubble appreciation rates, but I think it’s realistic to expect real estate prices will at least keep up with inflation (or perhaps beat it slightly) in most markets going forward. Unfortunately, there’s a very direct inverse relationship between interest rates and home prices. If interest rates go up, expect real estate values to drag. Thus, real estate isn’t a good substitute for bonds if you’re afraid of a bond bubble.

Commodities

Commodities could be your best bet in the event of sudden inflation. They could also wind up being decent investments in the event of an economic boom, as demand for raw inputs tends to increase when times are good. But here’s the problem: commodities are extremely volatile – every bit as volatile as stocks, in fact. It doesn’t doesn’t make sense to sell a mostly-safe asset (bonds) because of the possibility of a small price drop in order to buy an asset with a proven history of volatility. Commodities could go up, or they could go down. The point is, if they do go down, they will probably go down far more than bonds will even in the worst-case scenario.

Stay The Course, And Shorten Your Duration If You Must

In light of the facts, it just doesn’t make sense to get out of bonds at this juncture. You’d be trading a likely small loss over the short term for a possible large loss over the intermediate term. That’s not a smart bet to make. I do think there’s an argument to be made for shortening up your bond exposure, though. If you hold long-term bonds, I wouldn’t argue against moving to short or intermediate-term bonds. If you hold intermediate-term bonds, I wouldn’t give you any flak if you chose to move into short-term bonds. But sell out completely? That’s probably the worst thing you could do!

What do you think? Are you staying the course with bonds or have you gotten out?

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3 Responses
  1. 2013 April 1

    Long term bonds always have greater interest rate risk, because there is always possibility that interest rates will increase during long duration and bond prices fall. Therefore bond owners may force to sell bonds. Where as for short term bonds, risk is always less. So if you are looking for investing, then it is better to have short term bonds, than long term.

  2. 2013 April 2

    Long-term government bonds are in the unique position of being an openly declared bubble. The Fed has been buying 30-year Treasury bonds, driving up the price and driving down interest rates, for the past several years in order to help the economy. They’ve also influenced shorter term Treasuries for the same reason. Unless you think the world is going into a big 1930s-style deflationary spiral, there’s absolutely no reason to buy long term-term government bonds. You are only going to get burned once the Fed takes their foot off the gas, which they said they will do once the unemployment rate drops below 6.5 percent.

  3. 2013 April 4

    That’s kinda the point though, isn’t it? Bonds are supposed to be a hedge; everyone gets more money at their job when the stock market is doing fine so it’s cool when bonds don’t do so well.

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