Them rates go rising: Should I own bonds in a rising rate environment?

“The individual investor should act consistently as an investor and not as a speculator.”
— Benjamin Graham

Airbnb wasn’t always the global travel behemoth it is today — it took some luck, but more importantly, perseverance to stay the course. The founders used a binder full of credit cards to fund the start-up. When they maxed out all their credit cards, they decided to come up with a new idea. This was during the McCain-Obama elections, so they turned boxes of Cheerios into ‘Obama O’s’ and Cap’n Crunch into ‘Cap’n McCain’ with a hot glue gun. Eventually, their tenacity paid off when they showed Y Combinator co-founder Paul Graham a box of Obama O’s and got their company accepted into their accelerator program.

Rising interest rates have made investors nervous about investing in bonds. But you too, should stay the course.

Why do rising interest rates make bond investors want to run to the hills? Let’s say you own a Cheerios bond, which is paying you a 5% coupon for the next 10 years. If Cheerios issues new bonds at 10%, then clearly, everyone will want the new bonds and therefore the price of your existing bonds will fall. Of course, the reality is more complicated with duration being a key factor. But the simple fact is that when yields rise, the price of bonds falls and vice versa.

It is indeed a paradox — as a bond investor, you want higher yields to generate higher income, but the process to get to higher yields means negative price movements for the bonds you already hold. However, unlike equities, bonds have a maturity which results in reinvestment risk, as you need to reinvest the principal that is returned when bonds mature. PIMCO has demonstrated that over the long-term, investors holding diversified bond portfolios are better off if rates rise because they are able to reinvest at higher rates. Furthermore, for long-term investors who hold a bond to maturity, the price of the bond can fluctuate, but the total return of the bond does not change as the bond will redeem at par at maturity (provided the company does not default).

The US Federal Reserve has already raised rates 7 times to 2% this cycle, with at least 2 more hikes expected to get to 2.5%. We are likely more than two thirds through the rate hike cycle, which has already been priced in by the market. When rates are at 0.25%, it is easy to say that rates will eventually rise. When rates are at 2.5%, it is more difficult to say whether rates will be north of 3.5% or below 1.5% in a few years time. Just like any other asset class, we cannot predict the future. The long-term investor will be rewarded regardless of where yields go from this point in the cycle.

It is also important to note that active bond funds have tools in their arsenal to manage their portfolios in a rising rate environment. The bond market is global and diverse, and different countries across the world have different rate cycles, with some on hold or even cutting rates as growth slows. Active managers can take advantage of different yield curve shapes across geographies and sectors to generate returns.

The below charts show the return of different parts of the bond market through historical rate hike cycles and the correlation between rising yields and forward returns. Needless to say, rising rates are not necessarily bad for bond investors.

Source: PIMCO

Source: PIMCO

There may be some volatility in the short-term pricing of bonds, but investors with a long-term investment horizon should not fear rising rates. It’s important to remember why you hold bonds in your portfolio in the first place — key reasons such as capital preservation, income and diversification (read our article here on the benefits of bonds). Research has shown that the more patience a bond investor showed, the more likely he or she was to come out ahead even after a series of rate hikes. (Source: Alliance Bernstein)

You can change the cereal you have for breakfast as many times as you like, but don’t be fickle about your asset allocation. Persevere in your bond investing strategy.

Originally published Jul 19, 2018 on endowus.com