Bond interest rates are at historic lows in response to the Federal Reserve’s efforts to stimulate the economy. Over six years ago the Fed took actions to stimulate the economy by reducing short-term interest rates to near zero and reducing longer-term interest rates through a bond buying program that included $45 billion a month of long-term treasury bond purchases and $40 billion a month of mortgage-backed securities purchases. As expected, the huge amount of buying pushed up bond prices, and drove interest rates paid to bond holders lower.
“The financial crisis that began in 2007 was the most intense period of global financial strains since the Great Depression, and it led to a deep and prolonged global economic downturn. The Federal Reserve took extraordinary actions in response to the financial crisis to help stabilize the U.S. economy and financial system. These actions included reducing the level of short-term interest rates to near zero. In addition, to reduce longer-term interest rates and thus provide further support for the U.S. economy, the Federal Reserve has purchased large quantities of longer-term Treasury securities and longer-term securities issued or guaranteed by government-sponsored agencies such as Fannie Mae or Freddie Mac. Low interest rates help households and businesses finance new spending and help support the prices of many other assets, such as stocks and houses.” (Federal Reserve)
Low interest rates make borrowing cheaper. Individuals and businesses may be encouraged to take out loans to purchase items they may otherwise not buy. Thus, the economy would be stimulated.
Low interest income paid to savers and bond holders persuade investors to move out of cash and bonds and buy riskier assets, such as stocks.
The question now:
What could happen to bond returns when interest rates rise?
We will look at a 20 year period of rising interest rates to see how bonds performed.
A review of bond interest rates from 1962 to 2014
First, let’s look at Chart 1 which illustrates interest rates on the 10-year Treasury bond from 1962 to 2014. Rates averaged 3.95% in 1962, peaked at an annual rate of 13.9% in 1981 (intra-year rates rose above 15%), and have been falling steadily to the current 2.4% rate. The risk for investors going forward is that rates will rise, pushing down prices which could result in losses for bond holders.
Chart 1
What happened to bond returns when interest rates went up?
To get a sense of what may occur to future bond returns when interest rates rise, I looked at annual government bond returns for the 20 year period from 1962 to 1981 when the trend was for rising rates. Chart 2 tracks the total return of short-term T-Bills, intermediate government bonds and long-term government bonds. The 10 Year Treasury bond rate line is for reference.
Chart 2
Annual returns for each year were positive for short-term T-bills. Intermediate-term bonds only had one negative year in 1969. Long-term government bonds experienced negative returns eight of the 20 years or 40% of the time; 1967, 1968, 1969, 1973, and 1977 through 1980. During the steepest rate rise from 1977 to 1981 T-bill annual returns rose from 5% to almost 15%.
Review of two components of total return
Total return includes the change in the price of a bond called capital appreciation (capital losses when bond prices fall), and the interest income received by an investor. We will look at the behavior of both return components. Total return assumes that income each month is reinvested, not withdrawn.
Capital appreciation/losses returns
During periods of rising interest rates prices declined leaving investors with capital losses for intermediate- and long-term bonds 15 of the 20 year. (Chart 3) Long-term bonds experienced capital losses much steeper than those of intermediate-term bonds.
Chart 3
The chart shows that when interest rates increased, bond prices dropped and investors incurred capital losses. The longer the time to maturity the greater will be a bond’s price movement. You can see that reflected in the chart. During the years when rates were rising long-term bond price declined the most. It is a visual display of what is referred to as the inverse relationship between interest rates and bond prices. For an example see https://goldenhillsgroup.com/portfolio/playing-it-safe-with-bonds/
You may notice that T-bills are not included in the Capital Appreciation Returns chart. The reason is T-bills mature in one year or less and are typically sold at a discount from the face value. For instance, you might pay $990 for a $1,000 bill. When the bill matures, you would be paid $1,000. The difference between the purchase price and face value is interest income. You will see T-bills on Chart 4.
Interest income returns
Note that when interest rates were increasing bondholders received higher interest income returns. (Chart 4) This rise in income helps to offset capital losses when interest rates rise.
Chart 4
Diversified portfolios
Since we don’t know which bond maturity will perform best, you can split your bond investments over multiple maturities. Again, using annual total returns for government bonds from 1962 to 1981, I created two hypothetical portfolios; one with 50% T-bills and 50% intermediate-term bonds, another with 50% T-bills and 50% long-term bonds. If you had invested $1,000 in the T-Bill – Intermediate portfolio it would have grown to $3,026 at the end of 1981. That is about $640 more than the portfolio with long-term bonds. (Chart 5)
Chart 5
Summary
The 20 years of upward trending interest rates reviewed in this article illustrates that investors suffered capital losses when interest rates rose. The losses were mitigated by increases in interest income and the reinvestment of income at higher rates.
If income had been spent rather than reinvested, returns would have been lower.
We have focused on government bonds to illustrate how bonds responded to rising interest rates. There are other classes of bonds, e.g. corporate bonds, treasury inflation protected securities, or foreign bonds you may want to include in your portfolio for additional diversification.
Future bond returns are unknown. History is not a guarantee of future returns. This article is for educational purpose only. It is not investment advice.
Chart 1 Source: St. Louis Federal Reserve Research
Charts 2-5 Source: Rita Janaky, data from Ibbotson Stocks, Bonds, Bills and Inflation (SBBI) Valuation Yearbook 2010