If rates continue to rise, investors fear their bond portfolio might suffer a permanent loss. But is that true?
Ever since Federal Reserve chairman Ben Bernanke suggested that the Fed might soon begin tapering off its $85 billion/month bond-buying program, the bond market has experienced turmoil. The yield on the 10-Year Treasury note has risen to 2.308% on of June 20, up from 1.63% on May 2, 2013.
The chart below looks at the best and worst annual bond market returns since 1983 using indices representing various sectors of the bond market. Since 1983, the worst single-year return across these bond market sectors was -4.9%, while the best was 25.2%.
Data Source: GW&K Investment Management
In the last 30 years, the bond market losses have not lasted more than two years based on the 2-Year Rolling Annual Periods. As rates rise, the income from the bonds gets reinvested at higher rates, thereby reducing the potential for extended periods of negative returns from bonds. Remember, over the long term, interest income – and reinvestment of that income – has accounted for the largest portion of total returns for many bond funds. Over time, the impact of falling market value of the bonds might be offset somewhat by income and reinvesting at higher coupon rates.
There is some truth behind some of this bond bubble talk: historically, rising rates have meant falling bond prices. Bond holders can take advantage of opportunities to reinvest the income from current lower-rate bonds into higher coupon rate bonds; however, with current rates at such a low starting point, we don’t think investors should expect future bond returns similar to those we have seen in the last few years. But that doesn’t mean an increase in rates would be as bad as you might think.
Sources and Important Disclosures: Historical data above from Bloomberg, GW&K Investment Management, Mellon, and The Federal Reserve. 1983 represents the first full year that data was available for all indexes listed above. Data represents a variety of high quality bond indexes by Barclays Capital. As with any investment, past performance is no guarantee of future results. Fixed Income Investments are subject to interest, credit, and market risk, defined as follows. Interest rate risk: the value of fixed income investments will decline as interest rates rise. Credit risk: the possibility that the borrower may not be able to repay interest and principal. Low-rated bonds generally have to pay higher rates to attract investors willing to take on greater risk. Market risk: the bond market in general could decline due to economic conditions, especially during periods of rising interest rates.