Should We Be Concerned About Investing in Bonds?
Recently, a client asked-"Why should I buy bonds when interest rates are rising? It’s my understanding that when interest rates rise, existing bonds decrease in value.”
Typically, bonds play an important role within our portfolios as volatility reducers. Also, if you will need to withdraw investments for current needs over the next 1-5 years, it is important to maintain bond investments as “safe assets.” We choose to invest in bond funds rather than individual bonds for instant diversification, professional management, easy liquidation and lower expense costs. And while we know rising interest rates cause individual bond values to fall, we don’t know how long rates will continue to rise or exactly how rising rates will affect our bond funds.
So, why not jump out of bonds before rates climb, and then get back in after rates have settled? While the market-timing approach may sound like a good idea, it is a difficult strategy to implement, and is not nearly as effective as maintaining a properly allocated portfolio. After all, we’ve been saying since 2009 that interest rates mustgo back up, but it wasn’t until 2016 that rates actually started to tick up, and then only slightly. However, over the long term, it is the interest income and the reinvestment of that income that accounts for much of the total return of many bond funds. The impact of price fluctuation can often be greatly offset by staying invested and reinvesting income. Over time, the effect of compounding (i.e. interest earned on interest) can more than compensate for a market price decline.
To further complicate matters, there are different types of bonds and they don’t all react equally to interest rate changes. Bonds vary by maturity:long-term (10 years or longer), intermediate-term (3-10 year), or short-term (3 years or less); issuers:government and agencies, corporate, municipal, international; andtypes: callable bonds, zero-coupon bonds, inflation-protected bonds, high-yield bonds, etc.
So, while we cannot see the future, we can see how bonds have reacted to interest rate changes in the past. In the chart below, the total returns for several bond funds that we use regularly are listed for the years 2000 through 2017. The federal funds rate is also recorded for each of these time periods on the bottom row. Comparing the performance of each bond fund to the increase or decrease in the federal funds rate from year to year, you can see the two are not always correlated.
The 2000-2007 market conditions reflected interest rates decreasing dramatically from 2000-2004 and then suddenly increasing rapidly through 2007. But bond funds continued to hold up nicely until the Great Financial Crisis of 2008. And while some bond funds experience significant losses in 2008, all bond funds did not. Hence, diversifying into different types of bond funds does pay off. As demonstrated in the chart above, a diversified portfolio of bonds can be “safe assets,” even in a rising interest rate environment.