When interest rates rise, bonds lose value. But unlike default risk, interest rate risk is a temporary loss with the silver lining of more income going forward.
Still, it’s important to understand just how big interest rate risk is.
To get an idea, let’s look at the largest bond ETF in the world—the Vanguard Total Bond Market ETF (BND). It follows the Bloomberg Barclays U.S. Aggregate Float Adjusted Index of investment grade bonds. As of July 12, 2018, BND was yielding 3.12% and had a duration of 6.1 years. BND is a high-quality intermediate-term bond fund that is similar to the iShares Core U.S. Aggregate Bond ETF (AGG) and the Schwab U.S. Aggregate Bond ETF (SCHZ).
I asked Vanguard to illustrate interest rate risk for me on this bond fund, and they came back with the following chart below. It assumes, for simplicity’s sake, that rates rise immediately and then stabilize in future years.
(For a larger view, click on the image above)
To break this down, let’s take a 2-percentage-point interest rate rise as an example and see what’s its impact on returns. That would mean rates jump up today from 3.12% to 5.12%.
According to these estimates, BND would lose about 8.08% for the year. Though not good, remember stocks have lost over 20% in a single day before, on Black Monday.
Despite what may seem like steep losses associated with interest rate hikes, all is not lost. Keep in mind that BND is a laddered bond portfolio and Vanguard will now be buying new bonds paying an average yield of about 5.12%.
This extra yield results in the total return being positive by year three and, by year seven, the total return being the same 3.12% annually as if rates hadn’t risen at all.
In other words, the investor completely recovered from the initial shock as long as he or she didn’t panic and sell.
The one caveat is that the higher rate may be due to higher inflation, so you could still be behind in real inflation-adjusted terms.
Murky Crystal Ball
Now, before you say it’s a forgone conclusion that rates will rise, consider the fact that the nation’s top economists have forecast the direction of the rate on the 10-Year Treasury bond correctly about 30% of the time. That’s less than a coin flip.
In the chart below, you can see the impact of Fed rate increases on short-term rates while intermediate and long-term rates have barely budged. Only in the last six months did the 10-Year T-bond rise significantly and the top economists were finally right.
Rich Powers, Head of ETF Product Management at Vanguard, says the best forecast for the 10-Year Treasury Bond rate a year from now is the same rate as today. I completely agree. If the market actually knew that rates were going up on this bond, it would bid a price that has already taken that into account. It seems obvious enough, but sometimes obvious points aren’t so obvious.
Those who stayed focused on the short-term and earned virtually nothing until recently lost out. Those who took default risk by buying high yield bonds sometimes lost dearly. Remember that another name for “high-yield” bonds is “junk,” which I personally think is a better, more accurate name.
Don’t think for a minute that owning individual bonds eliminates interest rate risk. Bonds are riskier than bond funds. Stick with a high-quality bond fund such as those ETFs named earlier.
While today the extra reward for taking on intermediate-term interest rate risk is less than it used to be due to the flatter yield curve, there is still some extra reward. Over the long-run, the odds of a high-quality intermediate-term bond ETF besting a short-term of the same quality are very high. That is, as long as you can stay the course.
Allan Roth is the 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 the Wall Street Journal, AARP and Financial Planning magazine. You can reach him at [email protected] or follow him on Twitter at Allan Roth (@Dull_Investing) · Twitter.