What’s worse than rising interest rates? Low interest rates

Whenever I’m asked how I think bonds are going to perform, I always use a 3-year time horizon. I don’t claim to possess any particular prognosticative power over periods of weeks or months. But over longer periods, I can predict returns with a high degree of accuracy using my trusty one-variable model: the current yield.

If you’re looking for higher long-term bond returns, you need higher interest rates

Of course, there’s nothing revolutionary about my approach. A passive bond investor will find it hard to achieve performance that’s much better, or much worse, than the current yield. To some extent, even more active investors are tethered to current yields. Sure, a fall in interest rates might net you a tidy profit if you choose to sell your bonds, but to what end? Those profits need to be rolled into a new security that can deliver a decent rate of return with minimal risk. Such investments are few and far between in the current world of ultra-low interest rates.

Falling interest rates are good for bond returns over the short term but harmful over the long term — as anyone living on a fixed income since 2008 can attest. But what many investors miss is that, logically, the reverse is also true. Rising interest rates hurt bond investors over the short term, as they did in 2013. But they’re also the only path back to a steady state of 4%-6% annual returns on high-quality fixed income over the long term.

Interest rates are unlikely to fall forever, certainly not at the pace we’ve seen over the past several decades. That will be a good thing for bond investors over the next 5 to 10 years and beyond. But it also implies that investors may want to consider some changes to their core bond strategy over the next 1 to 3 years. Simply holding securities with very low yields and high interest-rate risk isn’t an optimal investment strategy. Diversifying into less rate-sensitive but higher-yielding segments of the global fixed income market makes a lot of sense. A bond portfolio that doesn’t include some U.S. corporate high-yield and/or emerging-market debt, for example, might benefit from adding exposure to these asset classes.

Recent history has shown that there’s no substitute for high-quality, long-duration bonds in a portfolio when equity and credit markets turn ugly. So the question is not so much whether to hold them but how large an allocation they deserve. Investors today are being better-compensated for accepting equity, credit, and currency risk than they are for taking on interest-rate risk. Prudent asset allocation and implementation should reflect this reality.

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Disclosures
This material is prepared by and represents the views of Brian Nick, and does not necessarily represent the views of TIAA, its affiliates, or other TIAA Global Asset Management staff. These views are presented for informational purposes only and may change in response to changing economic and market conditions. This material should not be regarded as financial advice, or as a recommendation or an offer to buy or sell any product or service to which this information may relate. Certain products and services may not be available to all entities or persons. Past performance is not indicative of future results. Economic and market forecasts are subject to uncertainty and may change based on varying market conditions, political and economic developments.
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