How bonds fared as Fed has raised rates
Joel Dresang: Kyle, often news reports make investors anxious about things. We’ve been hearing a lot about the Federal Reserve’s plans for eventually raising short-term interest rates. How concerned should bondholders be about that?
Kyle Tetting: Joel there’s been a lot of talk in the popular press about the overnight rate increasing sometime in the near future. The immediate concern is that as interest rates go up, bond prices tend to go down, but I think there’s a lot more to it than that.
Joel: So what do we know about bond funds and how they’ve performed in the past when rates have gone up?
Kyle: Since 1985, there really have been four major periods of rising interest rates. Two in particular I think that stand in stark contrast kind of tell a different story.
One, the period in 1994, where the overnight rate moved pretty significantly in a pretty short period of time. In the span of a year – from February of ‘94 to ’95 – we raised the overnight rate three percentage points from 3% to 6%.
The markets really responded unfavorably to that. It was a bit of a surprise that they raised at all, and how quickly they raised was a bit of a surprise as well. In 1994, the worst year that we’ve had for bonds in the past 25 years. The kinds of things that we invest in – intermediate-term, high-quality corporate bonds – down about 2.5% in that period.
The other one to keep in mind is the 2004 period of rising interest rates where we raised the interest rate much more significantly from 1% to 5.25%, but the impact was not nearly as severe because we did it in a much more measured and much better explained pace.
You know, the Fed was very clear on what the goal was, and once they reached their objectives, they let off the gas.
Joel: So as you said, when rates go up, bond prices usually go down. How come in the 2004 example the return actually went up when the rates went up?
Kyle: What really matters is that although the price of bonds did fall a bit over that period, we were getting income from those bonds along the way. And we got enough income to offset that decline in prices.
So one of the things we like to look at is the net return, you know, net-net, how have you done in your bond fund? Did you make money when you add in the fact that that the interest you’re receiving adds to whatever you may have lost in prices?
Add in the fact that along the way, you have bonds maturing. You can buy into those higher interest rates because, again, interest rates are going up in the new bonds that are being issued. You know, a great opportunity to add some value for bondholders long-term by just increasing the interest rate on the bonds that they’re holding.
Joel: So Kyle what are our expectations now?
Kyle: We’re looking at something that’s much closer to 2004 than it is to 1994. The Fed has been very clear about what their expectations are for where we’re headed and what their expectations are for how we’ll get there.
We have historically thought that those overnight rates should be somewhere around 4%. I think the Fed has very clearly communicated that that target now is much lower than it has been, somewhere around 2% to 2.5%.
But as always, you know, there’s no crystal ball in this, and anything could happen. So I think it’s incredibly important for investors to remember that it isn’t about betting on the outcome but rather making sure that you’re well diversified around it.
Joel: How should bondholders be positioned right now?
Kyle: We really focus on the shorter-term, higher-quality corporate bonds that are out there right now. I think there’s incredible opportunity to really diversify a portfolio in that area of the market.
Joel: What’s the message here for bondholders?
Kyle: Bondholders need to remember why it is they hold bonds. Ultimately, you know, bonds provide balance to a broader portfolio. Bonds provide that first source of income should everything else be not working the way we expect. And so important to remember that a bad year in bonds looks nothing like a bad year in stocks.
You know, down that 2.5% in 1994, as opposed to 2008, where many of your stock fund probably were down 30%, 40% or more. Bonds really are that piece that provides a certain measure of safety for investors.
Kyle Tetting is director of research at Landaas & Company.
Joel Dresang is vice president-communications at Landaas & Company.
(initially posted Dec. 1, 2016)