No Pain, No Gain: The Only Cure For Low Bond Returns Is Rising Rates
Summary High on the list of investor fears heading into 2016 is a “rising rate” environment. Over longer-term time frames, it is the level of interest rates, not their direction, that is the most important driver of returns. The low yields of today portend lower long-term returns. The only way out of this situation is pain, with rising rates leading to short-term losses but the promise of higher. High on the list of investor fears heading into 2016 is a “rising rate” environment. Déjà vu indeed. This has been a concern among investors for years now. With the Federal Reserve increasing interest rates this month for the first time since 2006, these fears have only been exacerbated. When it comes to investing in bonds, are these fears warranted? At first blush, they would seem to be. As bond prices move in the opposite direction to interest rates, rising rates can be a short-term headwind for bond returns. As we will soon see, though, the key to this sentence is short-term. Over longer-term time frames, it is the level of interest rates, not their direction, that is the most important driver of returns. We have total return data on the Barclays Aggregate US Bond Index going back to 1976. Since then, bonds have experienced only 3 down years: 1994, 1999, and 2013. In each of these years interest rates rose: 239 basis points (2.39%) in 1994, 151 basis points in 1999, and 74 basis points in 2013. (Note: the worst year for bonds was -2.92%, incredible when you consider that the fear of bonds today exceeds the fear of stocks). While certainly a factor over a 1-year time frame, when we look at longer-term returns the direction of interest rates becomes less and less important. The most important driver of long-term bond returns is the beginning yield. Why? Simply stated: when bonds approach maturity, they move closer to their par value and the short-term gains or losses from interest rate moves disappear. What you are left with, then, is the compounded return from the starting yield and reinvestment of interest. The relationship is immediately clear when viewing the chart below which displays starting yields by decile (lowest decile = lowest starting yield) and actual forward returns. The higher the starting yield, the higher the forward return and vice versa. (click to enlarge) The close relationship between beginning yield and future return has persisted throughout time. While rising rates can be challenging for bond holders over short-term periods, they are a positive for investors over longer periods as interest payments and maturing bonds are reinvested at higher yields. (click to enlarge) From 1977 through 1981, the yield on the Barclays Aggregate Bond Index rose each and every year, moving from 6.99% at the beginning of 1977 to 14.64% at the end of 1981. Over this 5-year period, bonds were still positive every year though performance was subpar. How was this possible? Again, the starting yield of 6.99% provided a cushion for returns as did the reinvestment of interest/principal at higher yields. The short-term pain from the rise in yields from 1977-1981 would lead to long-term gains for bond investors. The next five years would witness the highest 5-year annualized return in history at nearly 20%. This was achieved due to high starting yields and a decline in rates over that subsequent period, with the beginning yield again being the most important factor. No Pain, No Gain As I wrote back in May (see “Bond Math and the Elephant in the Room”), bond investors today are faced with their most challenging environment in history. The low yields of today portend lower long-term returns. The only way out of this situation is pain, with rising rates leading to short-term losses but the promise of higher future returns. If investors were objective and rational, then, the greatest fear would not be “rising rates” but a continuation of the lowest yield environment in history. Or worse still, “falling rates” from here which would provide a short-term boost to returns only to guarantee even lower long-term performance. This writing is for informational purposes only and does not constitute an offer to sell, a solicitation to buy, or a recommendation regarding any securities transaction, or as an offer to provide advisory or other services by Pension Partners, LLC in any jurisdiction in which such offer, solicitation, purchase or sale would be unlawful under the securities laws of such jurisdiction. The information contained in this writing should not be construed as financial or investment advice on any subject matter. Pension Partners, LLC expressly disclaims all liability in respect to actions taken based on any or all of the information on this writing. CHARLIE BILELLO, CMT Charlie Bilello is the Director of Research at Pension Partners, LLC, an investment advisor that manages mutual funds and separate accounts. He is the co-author of three award-winning research papers on market anomalies and investing. Mr. Bilello is responsible for strategy development, investment research and communicating the firm’s investment themes and portfolio positioning to clients. Prior to joining Pension Partners, he was the Managing Member of Momentum Global Advisors previously held positions as an Equity and Hedge Fund Analyst at billion dollar alternative investment firms. Mr. Bilello holds a J.D. and M.B.A. in Finance and Accounting from Fordham University and a B.A. in Economics from Binghamton University. He is a Chartered Market Technician and a Member of the Market Technicians Association. Mr. Bilello also holds the Certified Public Accountant certificate.