When Rates Start Heading Upwards Is It Time To Bail Out Of Bonds?
For the last 30 years, beginning in the early 1980s, interest rates had been following a long-term downward trend, as can be seen in the chart below. Declining interest rates are good for bondholders – as rates drop, bond prices rise.
Most economists predict that we are now entering a long period of rising bond rates, similar to the period from 1950 through 1980. Since rising rates tend to drive bond prices down, should we be dumping the bonds we own right now?
The short answer is no. You should always keep some allocation in your portfolio to bonds, both as a diversifier and, especially for retirees, as a source of income. In fact, different bonds respond to rising rates in very different ways, so the types of bonds you choose will make a big difference in your returns.
What are the best kinds of bonds to own in an inflationary environment?
First, there are Treasury Inflation-Protected Securities, or TIPS. Their prices adjust not only with changes in prevailing interest rates but also based on the rate of inflation, as measured by the CPI. In a Federal Reserve Bank of Boston discussion paper in 2009, Michelle L. Barnes, Zvi Bodie, Robert K. Triest, and J. Christina Wang write “we conclude that, as is, the TIPS market provides a good hedge against inflation risk … a ladder of TIPS, with maturities linked to when money is needed for expenses, would help investors in or near retirement hedge against their nominal expenses over time.”
Another good choice would be foreign bonds. Not only can you find relatively safe bonds with current local interest rates providing a higher return than those in the U.S., but currency exchange rates often vary independently of bond interest rates, providing an additional boost to returns in U.S. dollars when inflation here is higher.
Even in the U.S., there are bonds that can go up in price despite rising interest rates. One example is convertible bonds, which contain a provision allowing the holder to convert the bonds into shares of company stock at a predetermined conversion ratio. The prices of such bonds can be more correlated with equity price movements than with interest rates. Another example is mortgage-backed securities (MBS), which are packages of mortgages traded as securities. Notwithstanding their notoriety as one of the primary causes of the credit crash of 2008, many are currently priced at levels that do not reflect their true value. “In our view, real values exist in this sector for investors with the expertise to conduct in-depth analysis at the loan level,” says Kathleen Gaffney of Loomis, Sayles & Co., a bond mutual fund company.
Lastly, keep in mind that although rates are expected to rise over the long term, the path is far from smooth. As the chart shows, there were many multi-year periods during the last rising-rate era when rates dropped, providing good return opportunities for bond investors.
In summary, not all bonds are created equal. Selecting the right types can help keep your portfolio diversified regardless of what interest rates happen to be doing.