Bracing for Bondageddon

April 18, 2012

"Bondageddon" now?

Dire warnings about the coming collapse of the US bond market have grown in frequency and volume over the past two years. Some of these warnings have come from very prominent voices: Warren Buffett was quoted saying that bonds are "dangerous" and "should come with a warning label," while Professor Burton Malkiel of Princeton suggested in aWall Street Journal editorial that bonds are no longer appropriate for "prudent" investors.

We believe warnings like these are dangerous and imprudent because they may lead investors to abandon diversified portfolios and unwittingly take more risk. Let's put the situation into perspective: Bond yields have been falling for more than 30 years. The 1.8% low in 10-year US Treasury yields reached at the end of January may be the lowest level we see for a while. However, the "spike" in rates from those lows has been pretty modest.

Ten-Year US Treasury Yields Trend Steadily Downward

Source: Bloomberg, as of March 29, 2012.

In our view, current economic conditions don't point to a risk of a significant increase in rates in the near term. Although the US economy has shown signs of stronger growth, Europe has tipped into recession and leading indicators for some major emerging-market economies such as China and Brazil are slowing. As a result, central banks around the globe have been lowering interest rates. Inflation pressures have actually eased since late last year despite the recent rise in energy prices. Finally, we see longer-term demographics pointing to rising demand for fixed income as the population ages.

OECD Composite Leading Indicators for US, Europe, Brazil and China

Source: The Organisation for Economic Co-operation and Development, an organization that monitors events in its member countries, as well as others, and makes regular projections of short- and medium-term economic developments. Y-axis represents OECD composite leading indicator.

Nonetheless, there's clearly less upside than downside potential in bond prices overall. We think that some of the forces driving bond yields lower in the past few years, such as fears of deflation and the risks in the global banking sector, have begun to abate. With the US economy seemingly on the mend and yields low relative to inflation, bond valuations look stretched. Once the economic expansion is established, the Federal Reserve will likely begin to raise interest rates, probably in 2013 or 2014. However, longer-term bond yields have historically moved higher six to nine months before the Fed raises short-term rates for the first time in a cycle.

Don't panic—strategize

Despite headline-grabbing warnings, we believe the risk of rising rates is no reason to panic or abandon the bond market. Bonds can serve an important function in your portfolio: They help generate income and provide diversification from stocks. These attributes have been important factors in helping stabilize portfolios over the past decade, while stock prices have been volatile.

In addition, the bond market is large and varied. There's no single bond in the bond market, any more than there's one single stock in the stock market. The types of bonds or bond mutual funds you hold can make a big difference in the way your portfolio performs when interest rates rise. Moreover, you'll only realize a loss on an individual bond if you sell it or if the issuer defaults. Even in bond funds, the net asset value of the fund will likely decline if rates rise, but the fund manager may be reinvesting in higher-yielding bonds, so the income received may rise even though the net asset value is declining.

First, do the math

A first step is to assess the impact a rise in rates may have on your bond portfolio. "Duration" is a term used to measure a bond's sensitivity to changes in interest rates. The concept is similar to maturity, in that longer-term bonds usually have longer durations and tend to be more volatile than shorter-maturity bonds. In general, the longer the duration of a bond, the more its market value is going to fluctuate with the interest-rate cycle.

Although duration is a complicated concept, the most important part to remember is fairly straightforward—it represents the percentage change in a bond's price give a 1% rise or fall in interest rates. For example, if you own a 10-year bond with a five-year duration and interest rates decline 1%, you should expect it to gain 5% of its value. The opposite is also true: A 1% increase in interest rates will mean an expected 5% decline in the value of a bond with five-year duration.

What if Rates Rise?

Source: Barclays US Aggregate Bond Index, as of March 9, 2012. Illustration assumes the Barclays US Aggregate Bond Index modified adjusted duration of 4.97 years, semiannual compounding, reinvestment of coupons at prevailing interest rates and a rate shift immediately after purchase. Numbers may not add up due to rounding. For illustrative purposes only.

In our hypothetical example, we assume interest rates suddenly jump from 2.5% to 4.0%. If you were unlucky enough to buy a five-year-duration bond yielding 2.5% just before rates rose to 4.0%, it would immediately decline in value. However, if you continue to hold it and reinvest the interest, then the total return (income plus price) would be in positive territory after two years. The example is purely hypothetical and simplified, and assumes that rates stay flat for four years after the rise in the first year—but it illustrates one potential path of a bondholder's return in the event of a jump in interest rates.

Most bond funds will provide an estimate of the fund's average duration in their reports to investors. For individual bonds or portfolios of individual bonds, you can estimate duration by adding up the yearly income payments, giving greater weight to the payments made sooner rather than later, and then dividing the payment total by the bond price. Your Schwab representative can also help find a bond's duration.

Second, consider various strategies

1. Reduce the duration of your bond portfolio. If you're holding long-term bonds that have appreciated in value, it might be time to realize some gains on those holdings. Although you'll no longer receive the income from those bonds, it's reasonable to reduce duration to a level where you're comfortable with the potential impact on your portfolio.

We're fans of bond ladders because they’re designed to provide income and flexibility. Ladders spread out maturities of bonds over time. Shorter-term bonds on the lower rungs of the ladder should generally be less volatile and provide cash for near-term needs or for reinvestment. Income generated from the longer-term bonds on the higher rungs of the ladder can be reinvested and compounded or consumed, depending on your needs. Bond ladders can comprise any type of bond—municipal, corporate or Treasury—or a mix of various types.

2. Consider higher-coupon bonds. All else being equal, bonds that pay higher coupons (current income) are less volatile than bonds with lower coupons. Higher-coupon bonds generate more current cash flow that can be reinvested in a rising-rate environment. Money received today is worth more than money received later. Consequently, bonds that generate more cash flow up front tend to have higher prices and be less volatile than those for which the cash flow is paid out at a lower rate over time. Not surprisingly, bonds with higher current coupons may trade at a premium to their par value when rates are low and decline less than lower-coupon bonds when rates rise.

Higher-Coupon Bonds Less Sensitive Than Lower-Coupon Bonds

Source: Bloomberg, Schwab Center for Financial Research. The illustration above is for two 10-year Treasuries: a "seasoned" older Treasury issued when rates were higher with a 5% coupon; and one issued with a 2% coupon closer to the market rate today. The bond with a 5% coupon is selling at a premium compared to the bond with the 2% coupon that is pricing at par. The chart assumes a 1% and 2% increase in the 10-year interest rate. Illustration assumes semiannual interest payment and an immediate change in interest rates after purchase. For illustrative purposes only.

3. Decide on the amount of credit risk you're willing to take. Credit risk refers to the risk of default—the chance that you won't get your money back. One way to try to earn more income without taking more duration risk is to take more credit risk. Investment-grade corporate bonds (those rated BBB or above) usually yield more than Treasuries. However, credit quality varies depending on the sector and the issuer. Moreover, if interest rates rise, the value of these bonds will most likely decline as well.

Sub-investment-grade (or "high yield") bonds have tended to outperform other sectors of the bond market when rates rise, because interest rates tend to rise when the economy is getting stronger and economic growth is generally positive for companies that issue high-yield bonds. With stronger economic growth, conditions for improving their earnings and cash flow are better, which in turn may mean they have an easier time paying interest on their bonds. In addition, high-yield bonds tend to have shorter maturities than other types of bonds and higher coupon rates. The offsetting factor is that high-yield issuers are less creditworthy, so the risk of default is higher than with other types of corporate bonds.

4. Diversify globally. International bonds can also help provide diversification in a fixed income portfolio, because economic cycles aren't always in sync around the world. International bond funds may or may not hedge the currency risk in owning foreign bonds. Either way, allocating some portion of a portfolio to non-US bonds has historically demonstrated diversification benefits.

5. Other types of bonds. Alternative bond structures such as floating-rate bonds or convertible bonds may make sense in a rising-rate environment. Coupon rates for floating-rate bonds are usually set to move up and down with an index, such as the London Interbank Offer Rate (LIBOR). Individual investors usually get access to floating-rate bonds through mutual funds. However, floating-rate bonds may come with greater credit risk than traditional corporate bonds, so it's wise to be cautious. In addition, many mutual funds use leverage in an attempt to boost returns, and if short-term rates rise, the leverage can reduce the fund's returns.

Convertible bonds are hybrids that combine characteristics of fixed income and stocks: They pay regular interest but can be converted to equity shares at certain price levels. Convertible bonds have historically tended to outperform traditional fixed-rate bonds in a growing economy with rising interest rates, but they can be volatile and less liquid than other sectors of the bond market.

Preferred securities are also frequently considered hybrids of debt and equity because they have characteristics of both. There are many types of preferred securities: Some are very close to bonds because they pay interest rather than dividends and have set maturity dates, while others are more like stock in that they pay dividends and are "perpetual," with no set maturity date. While yields tend to be higher for preferreds than traditional bonds, the risks are higher as well. If the issuing company needs capital, the dividend can be cut or eliminated. Due to their long duration and credit risk, these securities generally tend to be more volatile than bonds.

Avoid Bondageddon

You can't control interest rates, but you can control what's in your portfolio. We believe it's prudent to make sure your portfolio isn't over-allocated to bonds—especially long-term bonds. However, we believe it would be ill-advised to ignore the potential benefits of diversification and income generation that bonds can provide in an overall portfolio. The types of bonds or bond funds you hold should be based on your own needs and circumstances, rather than trying to time the interest-rate cycle. A fixed income portfolio should be constructed with the goal of matching your income stream with your needs over time, keeping in mind how much risk you're willing to tolerate.

Important Disclosures