Bond concerns are intensifying once again as investors worry the Federal Reserve’s low interest rate policies are nearing an end. Everyone knows rates have nowhere to go but up. And when they begin their long-awaited climb from today’s historically low levels, the prices of existing bonds will fall. It is only logical that investors should avoid the inevitable “bond market crash” by selling now, right? Not so fast. Research shows avoiding bonds during Fed rate hikes has not provided the benefit conventional wisdom suggests.
In a recent Financial Planning magazine article, Brigham Young University professor and author, Craig L. Israelsen, Ph.D., explained an experiment he conducted. He compared two balanced portfolios, the same in every way except cash was substituted for bonds in one portfolio during years when the Fed raised interest rates. The average annual returns of the two portfolios were virtually identical over the period studied (1976 through 2011)—a period comprised of almost an equal number of years with rate hikes and cuts. Average volatility was also similar. Even with the unrealistic advantage of perfect market timing (knowing exactly when to switch), there was no long-term performance edge to be gained from periodically adjusting the bond allocation.
The reality is nobody knows exactly when or how much the Fed will move rates. It is far more prudent and less risky to simply remain invested, reinvesting interest income as yields rise rather than make bets about notoriously unpredictable interest rates and bond prices.
So brace yourself— as we move forward, we are likely to see and hear even more stories about the growing threat of inflation, the imminent increase in interest rates and how bad this is for bond investors. These stories will likely place too much emphasis on short-term predictions and attempt to distract us from what is really important—bonds remain the most reliable tool for balancing stock risk.
It is true the Federal Reserve will eventually have to raise interest rates from their current low levels to keep inflation in check. For investors who reinvest income and replace bonds as they mature, or for those who own bond funds (which do the same), higher interest rates are good news. Higher rates mean new bonds added to the portfolio or fund will provide higher yields. And over time, the effect of compounding income—earning interest on interest—at increasingly higher rates will more than compensate for the initial price decline.