For the second Christmas in a row, the U.S. Federal Reserve gave investors the same gift: a .25% increase in short-term interest rates. The news was accompanied by a decline in bond prices which move in the opposite direction of rates. It also renewed talk in the media of a “bond rout” and sparked a wide range of opinions about how investors should react.
Despite the rekindled fears, rising rates are a positive development. They are a sign the economy is healthier and less dependent on the extraordinarily low interest rates put in place during the depths of the global financial crisis. For investors like us, it also means better long-term return prospects for our bond portfolios.
Going forward, we will earn more interest as the funds we own replace their maturing bonds as well as when we reinvest income. Over time, the effect of compounding income—earning interest on interest—at increasingly higher rates will more than compensate for the initial price decline.
Why not get out of bonds before rates climb further and get back in after prices have stopped falling? If only it were that easy. The reality is that nobody knows exactly when or how much rates will move.
Following the Fed’s December 2015 increase, for example, interest rates on many U.S. treasury bonds actually fell, pushing prices higher until late last year. It is far more prudent to remain invested, consistently collecting and reinvesting interest income. Making bets about notoriously unpredictable interest rates and bond prices is simply riskier and ultimately produces lower average results.
Speaking of risk, don’t forget why we own bonds in the first place. The primary source of risk in diversified portfolios is stocks. Bonds act as portfolio shock absorbers during the inevitable periods of stock market distress.
This attribute was on prominent display in 2008 as investors around the world fled stocks in pursuit of safety. High-quality government bonds—particularly U.S. Treasuries—once again provided the best downside protection. They not only held their value, but increased 11% while riskier corporate bonds, high-yield bonds and dividend-paying stocks fell 5%, 26% and 34%, respectively.
Stocks and bonds have a yin—yang relationship which works in both directions. If bonds do continue to struggle in the near-term, stocks are capable of picking up the slack. According to recent commentary from Vanguard’s research team, “When bonds declined in the past, the equity portion of a balanced portfolio often more than offset the decline.”
The threat posed by a bad year for bonds pales in comparison to a bad year for stocks. Since 1926, the worst 12-month return for intermediate-term Treasury bonds (similar to those anchoring Vista portfolios) was -6%. In contrast, the lowest 12-month return for U.S. stocks was -65%.
The bottom line is higher rates are welcome news, despite the short-term bond headwinds that may come with them. All asset classes experience ups and downs at different times and for different reasons. Their individual rise or fall is not cause for a strategy change.
Remember, one of the greatest benefits of being a disciplined, long-term investor with a diversified portfolio is you have already anticipated change and planned your work. All that is needed anytime new events unfold, is to work your plan.