Date of publication: August 30, 2019
If in a recession, we expect a severe drop (20%?) in the equity markets what changes in interest rates would we need to see for similar results in the bond markets? In other words, what happens when bonds break bad?
Rising rates have not been seen in more than a decade yet talking heads, writers and analysts are rightfully persistent in elevating this key risk of owning bonds. There are other risks of course including default and inflation risks being at the top of the heap. But the risk of rising rates gets the headlines. Eventually rates will rise. When and by how much is unpredictable despite the numerous voices telling us to invest here or there because of this specific risk. A more practical approach to understanding interest rate risk may be to look at specific scenarios.
Key to the analysis are some assumptions:
- All scenarios assume bonds or bond funds are purchased on August 30, 2019.
- All scenarios assume a parallel rise in rates across curve from current rates.
- As rates rise, durations shorten. In this example, I use the current duration of bond funds as the basis of the price calculations which results in an exaggerated price shift estimate.
- Coupon cash flow is an integral part of investing in bonds however for this illustration is not included in the calculations. (Example: all things being equal, a 2% yielding bond over 3 years would provide over 6% in return).
- I chose a 3 and 5 year horizon to examine rising rate impacts. Equally valid would be other time periods where rates could be expected to rise.
August 2022 (3 years) rising rate environment where rates rise from current rates by 2% (or 200 basis points)
August 2024 (5 years) rising rate environment where rates rise from current rates by 3% (or 300 basis points)
A 20% drop in bond prices is a significant impact but as you can see from the math illustrated in the tables it would take a large rate shift to impact bonds by that amount.
There are also differences in gaining exposure to the bond market via bond funds and individual bonds.
Individual bonds: If for example, I am a buyer of individual bonds and I intend to hold my bonds until maturity then some of my downside risk due to rising rates is mitigated as I intend to get my principal back upon maturity or early redemption. I also get the benefit of the “roll down” the curve. If I buy a 10-year bond today, in three years that bond is now a 7 year bond and a chunk of my duration risk is mitigated by that “roll down” as a result.
Bond funds: In effect owning a bond fund is owning a perpetual basket of bonds whose duration is managed to remain within a specific range. Benefits of bond funds include diversification and professional management. Owning a bond fund does not provide either the maturing at par aspect or the “roll down” benefit.
In both cases, as an owner of a bond or a bond fund I would have enjoyed the benefit of coupon cash flow during the period between August 2019 and August 2022 or August 2025. That cash flow can be a significant aspect of the return for bonds beyond the price movement seen as rates rise or fall.
In summary, a lot has to happen and could happen to drive rates higher and push bond prices down. Keeping perspective and understanding the risks and benefits of owning bonds or bond funds v. other asset classes in an economic downturn or rising rate environment is valuable as well. The old “bonds go down when rates rise” is true but also is a broad-brush stroke that doesn’t take the whole picture into account.
For more on the bond markets visit www.straighttalkaboutbonds.com.