Roth: Why Interest Rates Fooled Us

April 28, 2014

Using a laddered bond fund can soften the blow if and when rates do rise.

Going into 2014, it seemed all but certain that interest rates were going to rise. The Fed announced its plans to taper quantitative easing, meaning it was planning on reducing the amounts of its own debt being purchased.

In actuality, as of April 25, 2014, the 10-year Treasury yield fell from its recent high from last year of 3.04 percent to its current 2.67 percent. The Barclays Aggregate Bond Fund (AGG | A-97) has returned 2.22 percent, more than erasing the 1.98 percent loss from 2013.

Last November, I wrote in The Wall Street Journal Total Return Blog that economists surveyed by the paper predicted rising rates. In CBS MoneyWatch, I noted that advisors were reducing bond exposure with the possibility of a bond bubble.

What went wrong? How could both the top economists and financial advisors be so wrong? Well, in the Wall Street Journal piece, I referenced a study revealing these same economists surveyed had a track record of accurately predicting these rates well under 50 percent of the time, which is the expected outcome of a coin flip. And advisors as a whole consistently time the market poorly, as I noted in the CBS MoneyWatch piece.

Why did interest rates decline? While I may not have an exact answer, I do know that the bond market, just like the stock market, is not stupid. Smart investors understood that the federal government couldn’t continue to buy back its own bonds indefinitely.

And if one were actually going to outperform markets, one would have to know something that very few people know. Once the Fed announced its plans to taper, it was too late to act on the news.

In reality, lightening up on bond exposure at the end of last year was selling based on common knowledge and after bonds had declined. That’s the classic example of performance-chasing. Yes, interest rates fooled us, but it’s the norm rather than the exception.

What To Do Now?

The bottom line is that no one knows how intermediate- and long-term bond rates will perform. Looking at the yield curve, staying in short-term bonds or cash is a guarantee to lose spending power by not keeping up with inflation.

Buying long term only increases yield marginally compared with intermediate-term bonds, and takes on a much greater amount of interest-rate risk as those bonds will get creamed should rates rise. Thus, the intermediate-term bonds are a reasonable solution.

Bonds_Big

If rates rise, it’s important not to panic. The chart below illustrates what would happen if a shock to the financial system caused an instantaneous rise in rates.

Starting Yield 2.3
Duration 5.6
Instant
Annualized return
Years
1 2 3 4 5 6 7 8 9 10
0% 2.3% 2.3% 2.3% 2.3% 2.3% 2.3% 2.3% 2.3% 2.3% 2.3%
1% -2.8% 0.2% 1.2% 1.7% 2.1% 2.3% 2.4% 2.5% 2.6% 2.7%
2% -7.9% -2.0% 0.1% 1.1% 1.7% 2.2% 2.5% 2.7% 2.9% 3.0%
3% -13.0% -4.3% -1.2% 0.4% 1.4% 2.0% 2.5% 2.8% 3.1% 3.3%
4% -18.1% -6.7% -2.5% -0.4% 0.9% 1.8% 2.4% 2.9% 3.3% 3.6%
5% -23.2% -9.2% -4.0% -1.3% 0.4% 1.5% 2.3% 2.9% 3.4% 3.8%

Source: Vanguard analysis

Using an intermediate-term bond fund yielding 2.3 percent with a 5.6 duration, we can see the impact. If, for example, rates surged by 3 percentage points, that bond fund would lose an estimated 13 percent in that year.

But since a bond fund is a laddered bond portfolio, every month, bonds would mature and be reinvested at an average rate 3 percentage points higher, which translates into higher returns. Thus, for those who don’t panic, overall returns are positive by year four, and by year seven are higher than if rates had stayed flat.


Allan Roth is founder of Wealth Logic LLC, an hourly based financial planning firm. He is required by law to note that his columns are not meant as specific investment advice. Roth also writes for CBS MoneyWatch.


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