It is a fact that bond prices decline when rates rise. But what happens to total returns? That’s the only number that should matter to investors.
Here’s the scoop from Mark Hulbert, editor of the Hulbert Financial Digest, who has made a career out of rating financial forecasters and debunking performance myths.
“A review of past rising-rate periods shows that bond investments performed surprisingly well. So don’t be too eager to let the fear of higher rates lead you to sell your bonds and move into assets—such as gold—often billed as providing protection during such times.”
Hulbert looks back to the 1966 – 1981 period, thought by many to be one of the worst in U.S. history for bonds. During that period, the yield (or interest rate) on the five-year Treasury bond tripled. Yet, observes Hulbert, during that time a portfolio of intermediate-maturity U.S. government bonds would have produced a 5.8% annualized return.
How is that possible? Actually, it’s just simple math.
Bond returns have two main components.
One is the change in the market value of the bond. It can go up or down during the period. Generally, bond prices do decline when interest rates rise.
However, the second component of bond returns is the income flow. And when interest rates go up, your bond portfolio income goes up, as bonds mature and proceeds are reinvested in new bonds at higher rates.
Hulbert says rising income in-flows more than make up for declines in prices, resulting in a positive return for the investor.
Additional research appearing in the January-February issue of the Financial Analysts Journal confirms these results over an even broader time period. That research found that “as a general rule, the greater yield earned during a rising-rate environment offsets the declining bond prices those rates cause.”
In other words, concluded the researchers, bond investors “need not be unduly worried about the impact of higher rates on their multiyear returns,” reports Hulbert.
This doesn’t suggest that bonds will thrive in a climate of rising rates. But long-term investors with a well-designed bond portfolio can still profit from the stability, steady income and lower risk that bonds offer.