Do Rate Hikes Spell Trouble for Bonds?

Is this woman about to ruin your bond returns? Photo by Getty Images.

Now that the Fed began raising rates, is it time to get out of bonds? Given bond prices move opposite interest rates, some may wonder if now isn't a time to exit fixed income. In our view, though, a closer look at Fed policy and bond markets suggests investors should not shun bonds just because the fed funds rate is up a wee bit.

Some claim Fed rate hikes will dent bond returns, so investors should reduce or eliminate their exposure to some types of bonds. But history doesn't support this. Since a potential Fed rate hike has been one of the most widely discussed financial events in recent history, bond prices likely already reflect the first rate hike. Markets tend to move in front of widely expected events, not after them, which has been demonstrated time and again in this bull market, including the ECB's recent moves. But also, long rates-mostly set by free market forces- don't necessarily move in lockstep with short rates set by the Fed. Many factors beyond what the Fed may or may not do influence long bonds. A lender (bond buyer) is giving the borrower use of funds for a longer period, exposing him or her to more risk of default, changing interest rates and more. Also, long-term bond yields frequently sway with inflation expectations. If a lender believes inflation will be 2% over the next 10 years, they will likely want a 10-year bond that yields more than 2%, to compensate them the loss of purchasing power throughout the life of the bond. Long rates often move with short rates, but the relationship is not direct. For example, between June 2004 and June 2006, the Fed raised the fed funds rate 17 times from 1% to 5.25%, but yields on the US Treasury 10-year note rose only about half a percentage point during this period. When you actually consider what investors' real experience was-interest payments plus price movement, or total return-bonds did just fine.

Exhibit 1: Bond Index Total Returns During the 6/30/04 - 6/29/06 Rate Hike Cycle

Source: Factset, as of 12/15/2015. Bank of America Merrill Lynch Bond Index series used for all bond types and maturity ranges shown.

The 1999-2000 hike cycle tells a fairly similar tale.

Exhibit 2: 6/30/99 - 5/16/00 Rate Hike Cycle

Source: Factset, as of 12/15/2015. Bank of America Merrill Lynch Bond Index series used for all bond types and maturity ranges shown.

Now, the bond types shown above responded fairly similarly, regardless of whether they were long or short maturities, corporate or Treasury. But the type of bond does matter in terms of how it responds to interest rates. Treasurys tend to be directly exposed to rates. Corporates, however, can respond to other factors. For example, it is common during maturing bull markets to see the difference between corporate rates and Treasury rates narrow, driven by rising investor confidence in corporations' health.

The 1994/1995 rate hike cycle is a good example of this. 1994, dubbed by some, "The Great Bond Massacre," was not exactly a massacre across the board. From February 1994 through February 1995, the Fed hiked the fed funds rate from 3.0% to 6.0%. Treasury bonds began falling in October 1993-likely pricing in inflation expectations and a potential tightening cycle beforehand. From this point through their trough in November 1994, long-maturity Treasurys (exceeding 10 years in maturity) fell -15.0%.^[i] However, shorter-dated Treasurys and corporates fell less and bottomed sooner-in May 1994, just as the Fed rate hike cycle was gaining steam. While long-term Treasurys were hit, the Bank of America Merrill Lynch US Corporate 3 - 5 Year Bond Index fell only -3.8% from its peak to its trough, which were just over three months apart.^[ii] As Exhibit 3 shows, before and after hikes began, the "massacre" is hard to detect.

Exhibit 3: 2/4/94 - 2/1/95 Rate Hike Cycle

Source: Factset, as of 12/15/2015. Bank of America Merrill Lynch Bond Index series used for all bond types and maturity ranges shown.

To materially benefit from avoiding bonds during this period, investors would need to have sold before the hikes began (ideally, in October 1993 when bond prices peaked)-and piled back in in May 1994, just a quarter of the way through the hiking cycle. Making matters worse, if you were late getting back in, you would have missed out on a great year in 1995: Corporates and Treasurys rose 21.5% and 18.4%, respectively.^[iii] Alternatively, you could have just shortened up the average maturity and focused more on corporates than Treasurys.

These periods highlight the fact it makes sense to sell bonds (and stocks too for that matter) only if you believe prices will fall by a lot and over a meaningful time period. It is almost impossible to accurately time relatively small, short-term asset price moves. Of course, with bond yields currently ultra-low, interest payments will offset falling bond prices less than in previous rate hike cycles. But at the same time, there is little reason to think the Fed is going to act rashly and raise rates precipitously. As we've written, Janet Yellen has a history of acting gradually, moving based on consensus. With a presidential election next year-and her first stint as Fed head up the following-we doubt she wants to act very dramatically now.

Perhaps your situation doesn't warrant owning bonds. That is entirely possible. But if you do, before eliminating exposure, consider the role fixed income can play in your portfolio.

Bond prices tend to be much less volatile than stocks, and while they do not always zig when stocks zag, some bonds can rise when stocks fall, a big volatility dampener. If you have sufficient cash flow needs, that can be a real plus, reducing the strain on your retirement money when stocks are experiencing high volatility. Now, of course, if you convert your bonds to cash, this will dampen portfolio swings too, but cash provides very low returns-actually, negative returns currently when you consider inflation. By adjusting your exposure to emphasize less interest-rate sensitive securities-shortening duration and focusing more on corporates-you can keep bonds to dampen volatility without accepting negative real returns inherent in cash today.