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Question of the Week - March 9, 2015

Question of the Week - March 9, 2015

Guest Post - Monday, March 09, 2015

Should we fear the Fed? What happens to bonds when interest rates really begin to rise?

Last week again showed us how normally stoic bond markets can move quickly when markets receive news they don't like, responding via rising rates. Fixed income investments, like traditional bonds and preferred stocks, generally react well to bad news, which perhaps explains why bond managers are considered to be the morbid antithesis of generally optimistic equity investors. Bonds perform best upon interest rates declining, and lower rates generally occur when things aren't going well, such as slowing economic growth, or outright recession or deflation. Of course, the extreme case of this is central bank easing through actually purchasing bonds, which drives the prices up and yields down, which is currently the case in Europe and Japan.

On the other hand, when things are proceeding well, we should expect rates to rise to varying degrees. This is a function of the assumption that accelerating economic growth will eventually lead to central banks applying the 'brakes,' to keep an economy from overheating. That's what we're faced with now in the U.S.—or at the very least, that the economy is growing just enough beyond stall speed to no longer warrant emergency Great Recession-level zero rates. Inflation is the other reason for doing this, but we're not faced with that yet, at least as measured officially.

Now, the difficulty comes in getting the magnitude and timing correct. Another complication is about which bonds will suffer most through interest rate increases, and this is a factor of non-parallel shifts in the yield curve, but this gets more complicated and even more difficult to predict. Bond managers that have experienced the generation of their lives (with bond returns at above-average levels from the high point in rates in the early 1980's) are scrambling to explain why rising rates won't be that bad for bond investors, as long as you're selective. While that's sometimes true at the margin, it can be difficult to buck broader trends.

Starting with the basic relationship, we'll walk through an example. Bond results come down to the taking of two specific risks: duration/maturity and credit quality (for foreign bond investments, currency is a third risk factor, not covered here). For Example 1, if rates were to rise in a parallel/equal fashion across the yield curve, this is what the math looks like. It may be a stretch for it to happen this precisely, but anything is possible.

If a parallel shift doesn't happen, per Example 2, and if rates rise a bit more on the front end (in line with increases in the Fed Funds rate) than they do on the back end, this is known as a flattening of the yield curve. Note that duration still plays a big role, even for small rate changes or situations when long bond yields don't rise as much as short yields do.

Term (Yrs) Implied Duration (Yrs) Start Yield % Yield Chg% End Yield % Duration Effect = -1 * Duration * Yield Change 6 Mo. Total Return % = Interest + Duration Effect
Example 1: Parallel Shift
2 2 0.6 +0.5 1.1 -1 * 2 * 0.5 = -1.0 0.3 + (-1.0) = -0.7
10 9 2.2 +0.5 2.7 -1 * 9 * 0.5 = -4.5 1.1 + (-4.5) = -3.4
30 21 2.8 +0.5 3.3 -1 * 21 * 0.5 = -10.5 1.4 + (-10.5) = -9.1
Example 2: Non-Parallel Shift / Flattening
2 2 0.6 +0.6 1.2 -1 * 2 * 0.6 = -1.2 0.3 + (-1.2) = -0.9
10 9 2.2 +0.3 2.5 -1 * 9 * 0.3 = -2.7 1.1 + (-2.7) = -1.6
30 21 2.8 +0.3 3.1 -1 * 21 * 0.3 = -6.3 1.4 + (-6.3) = -4.9
Disclosure: Hypothetical 6-month period showing simple relationship between interest rates and price effects for a single bond (results rounded for simplicity). Mutual funds with constant duration targets will behave differently. Other factors, such as changes in credit spreads, 'roll' effect, reinvestment of interest, prepayment risk and credit risk not considered. Durations for each maturity are based on recent estimates (Ryan Indexes, Wall Street Journal, as of 3/8/2015).

We didn't include changes in credit spreads, just to keep things simple, but those can often move in the opposite direction of rates outright to further complicate this math. So, while longer-term bonds would experience a higher yield at the end of the rate increase period, the road to get there could be volatile. Academic work has demonstrated that a bond investor's best estimate for total return is the starting yield-to-maturity (that's easy), but it can take a multi-year holding period, up to a decade or more in some cases.

Equities can behave well in a rising rate environment, because the same reasons that rates are rising—strong growth—also trickle down to the bottom line that matters most for companies in the form of higher earnings. Sure, in the short-term, there can be some volatility when rates begin to move, but research in this area shows that the year(s) following rate hikes can be quite profitable for equity investors. Stock markets tend to end not from growth, or even higher valuations outright, but from recession and other financial imbalances, such as credit meltdowns. Keep the 30,000 view in mind: economic growth is generally a good thing for risk assets, and recessions generally aren't. We may discuss equity effects further another time.

Additional Reading

Read our Weekly Review for March 9, 2015.

Read the previous Question of the Week for February 23, 2015.

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