Commentary by Roger Aliaga-Diaz, PhD, Chief Economist at Vanguard, USA and Head of Portfolio Construction
The yield on the 10-year U.S. Treasury note increased 100 basis points (1 percentage point) from August 2020 to the end of March 2021. Rates have also risen for other government bonds issued by the UK and Australia. This is because bond prices fall as rates rise, and conversely, some investors are worried about the near-term risk of bonds.
An increase in bond yields means lower bond prices
Daily yield of 10 year US Treasury notes, January 2, 2020-22 March, 2021
Bond investors should keep, not fold
In such market cycles, it is especially important to remember the role of bonds in a diversified investment portfolio – shock absorbers when equity prices fall.
The Vanguard study found that when global stocks sank by about 34% during the global financial crisis, the market for investment-grade bonds returned more than 8%. Similarly, the period from January to March 2020 – the height of volatility in equities due to the Covid-1 pandemic epidemic – global bonds returned only more than 1% while equities declined about 16%. And if we look at the various full-fledged business cycles, from January 1988 to November 2020, whenever the monthly equity return decreased, the monthly bond return was about 71% positive.D
Such incomplete returns demonstrate the advantages of diversification that provides investors with a balanced portfolio of stocks and bonds.
In short, do not let interest rate changes bring about strategic changes in your bond allocation. Myths and misconceptions about bond investing abound in times of rising rates, often with calls for drastic changes in your portfolio. Here are three common myths that investors should avoid:
- Myth # 1: “Bonds are a bad idea – abandon the 60/40 portfolio.” This heard recommendation opposes the over-emphasis on maintaining a balanced allocation in line with your investment objectives, as well as the delay in reaping any benefits from strategic changes in your asset allocation. Selling bonds after the recent rate hike, which has reduced prices and total earnings, is only following past performance. Investors should be on the lookout: At the current high yield, the bond outlook is actually better than before yield yields increased. Keep in mind that the higher the productivity side – the greater the interest income is coming. Also, the likelihood of future capital losses decreases as yields increase. So now is not the time to give up bond allocation. Conversely, the higher the yield on bonds (and the lower the price), the more important it is for long-term investors to maintain a strategic allocation for bonds, which may require restructuring of bonds, not vice versa.
- Myth # 2: “Go cash, avoid period risk.” Rising rates have hit long-term bonds hardest. But the recommendation to avoid period or interest rate risk falls behind and probably comes too late. Again, change your mindset to a far-sighted approach to the bond market. The downside of the market is that rates will rise, and the prices of short, medium and long term items already reflect that belief. Today’s market value of long-term bonds has already caused investors ’expectations for rising rates, making prices cheaper. If that sens reduction approach is effective, there will be no benefit in transferring to short-term bonds or going for cash. Such measures will be taken only if the long-term yield increases more than expected. However, it is equally possible that the yield will increase Less Long-term bonds will do better in this case than expected.
- Myth # 3: “When interest rates are rising, don’t stand there – do something!” The previous rate hike was a surprise for the markets, but now the markets expect continued growth. The rate that is rising is not really news anymore. Although there is actually the potential to increase yields, they may do more or less than market consent. Control what you can do: With a 50/50 chance of a low or low rate of sensation, a better approach than trying to choose which market segments will be the best in the near term is to stay well-diversified throughout the spectrum throughout maturity across the spectrum and asset class. .
Keep an eye on the street in front
This is good advice for both driving and investing. Vanguard recommends that investors focus on long-term, expected return expectations, not on recent reversal-return performance.
Let your investment goals decide the distribution of your strategic assets. Close the risk-return trade-off in your portfolio, including determining the right mix of bonds and stocks to meet that goal. And usually ignores market-time advice, which is largely based on universal usability information that has already been priced in the market.
Even if rates continue to rise, long-term gross earnings are likely to remain positive in widely diversified bond portfolios. This would be the normal result of reinvesting high-yield bond dividends, a process that is easily managed by ownership of a mutual fund or ETF.
Elephants in the house – inflation
Inflation is often seen as the enemy of fixed income investors, especially unpredictable inflation that has no market value.
The Vanguard study states that significant inflation hedging through inflation-related securities requires large terms, which could reduce the other diversification advantages of bond allocations in a portfolio. On the long-term horizon, equ has historically provided the strongest protection against equity inflation.2
Where the active can be bright
The growing rate environment also underscores what efficient active managers may be able to bring into a bond portfolio. When yields are declining, supervised fund managers deposit their additional returns on top of the generally rising prices in the market. But under the heading of rising rates and conventional price declines, successful active fund managers can distinguish between positive and negative total earnings.
Investors who are inclined to look for outstanding performance – and are aware of the risk of lower performance – should make the decision about their strategic change and safety choices left to professional active managers. Managers who have demonstrated proficiency in performing repetitive investment processes, under strict investment risk control – such as my colleagues at Vanguard Fixed Income Group – can manage portfolios successfully in market waters, calm and agile alike.3
D Renzi-Ricci, Giulio, and Lucas Baynes, 2021. Hedging equity downside risk with bonds in low yield environment. Valley Forge, PA: The Vanguard Group.
2 Bose, Paul, 2019. Products and Short-Term Tips: How Everyone Deals with Unexpected Inflation. Valley Forge, PA: The Vanguard Group.
3 In the 10-year period ending December 1, 2020, 44 out of 44 actively managed vanguard bond funds exceeded their peer-group averages. Results will vary for other periods. Funds with a history of at least 10 years in comparison were included. (Source: Lipper, a Thomson Reuters company.) Note that competitive performance data represents past performance, which is not a guarantee of future results and all investments are at risk. For recent performances, visit our website http://www.vanguard.com/performance.
For more information about vanguard funds or vanguard ETFs, visit vanguard.com to get a prospectus or, if available, a summary prospectus. The prospectus contains investment objectives, risks, charges, expenses and other important information; Read and consider carefully before investing.
Vanguard ETF shares are not redeemable without a very large consolidation of millions of dollars worth of issuing funds. Instead, investors must buy and sell Vanguard ETF shares in the secondary market and keep those shares in a brokerage account. In doing so, the investor can take brokerage commissions and pay more than the net asset value at the time of purchase and accept less than the net asset value at the time of sale.
All investments are at risk, including the potential loss of the original investment. Be aware that fluctuations in financial markets and other factors can reduce the value of your account. There is no guarantee that any specific asset allocation or combination of funds will meet your investment objectives or give you a certain income level.
Diversity does not guarantee gain or protect from loss.
Investing in bonds is subject to interest rates, credit and risk of inflation.
“Rising rates do not negate bond benefits”,