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Rising Interest Rates

14

Interest Rates Have Finally Started to Go Up

How could 98% of economists be so wrong?

In a Wall Street Journal survey conducted in May 2013, 98% of economists predicted that the yield of the 10-year Treasury note would be higher in December 2013.

This sounds like a sure thing, except when you consider that in May 2011, 98% of economists forecasted that interest rates were going to increase. Rates fell. In May 2012, 98% said rates would rise. They fell again.

The Wall Street Journal recently reported that those who acted on this sure thing (betting that rates would go up) would have lost about 8% of their money between May 2012 and May 2013. How could one lose $80,000 investing $1,000,000 on a strategy that 98% of economists recommend? It is all in the math that drives bond returns.

Crunching the Numbers

The rule of thumb is that if interest rates increase 1 percentage point, the percent decline of a bond will equal the bond’s “duration” in years. Conversely, when interest rates decline the value of a bond will increase by the “duration” Those who have owned bonds or bond funds over the past few years have certainly enjoyed the increase in value of their portfolio.

Most mutual funds publish the fund’s duration in years. The higher the duration the more sensitivity a mutual fund will have to changes in interest rates.

A Simple Example

Let’s say you own a bond with a 3% coupon interest rate with duration of 5 years. A 1% rise of interest rates would lead to a loss in market value of 5%. You would still receive your 3% coupon, so your net loss would be reduced to 2% for the year. The good news is that you will be able to earn a higher coupon rate once the bond matures. And the bond matures at its full face value.

Should I Sell My Bond Positions if I Am Convinced Interest Rates Are Moving Higher?

Meridian has consistently advised our clients to hold an all-weather, well-diversified portfolio in lieu of attempting to time the market.

Those who attempt to make calls on the forward returns of stocks versus bonds are going to have to get a lot of things right:
When to exit and then re-enter a market.
How will each asset class move relative (and to what degree) to the other.
Can you filter out the talking heads and not react to headlines that can be harmful to your portfolio?
Are you able to recognize that “experts” (like the 98% of economists cited above) can be wrong for years at a time?

What About Owning Bonds Vs. Owning Bond Mutual Funds?

Although the price of the bond mutual fund will fall when interest rates rise, you will be paid a market rate of interest from that point forward. When you own an individual bond, you will not take a loss at maturity, but you receive lower interest until the bond matures. We think that the end result is exactly the same over any meaningful time frame…it is simply that you are ripping the bandage off quickly with a bond fund. You are realizing the pain slowly when you own an individual bond.

Why Should I Continue to Own Bonds?

Some own bonds primarily to mitigate the volatility inherent in stocks. Some own bonds to provide a stream of income to pay expenses. Still others own bonds simply to preserve capital.

All of the above reasons are valid regardless of the bond coupon rate. Understanding why you own bonds will provide you with the proper perspective.

In the end, we believe that you are likely best served by maintaining a strategic allocation to a diversified mix of bonds. This will protect you when the next crisis occurs. Bonds in this context act as a diversifier for the riskier assets in your portfolio.

Understanding why you own bonds is one key. Diversifying your account is the other piece of the puzzle.

Call us if you need assistance with either.