Bond yields were on a largely downward trajectory for nearly four decades, reaching record lows in the 21st century in many developed countries. Real yields of reserve currency sovereign bonds — namely in the U.S., Western Europe and Japan — actually turned negative.
When yields get really low, it’s only a matter of time until they inevitably rise again, and rising interest rates push bond prices down because of the inverse relationship between the two.
Yields can’t stay low forever
That inverse relationship was on full display in early 2021, when market interest rates began rising sharply, and prices started getting crushed.
The impact on bonds is usually magnified when market interest rates go up sharply and quickly.
It’s also more pronounced off a low base — a concept known as convexity in bond circles. Convexity allows fixed income investment professionals to better understand the impact that yield changes have on bond prices and is especially important during periods of heightened volatility.
Investors who want to maintain some diversification in their portfolios but can’t stomach an all-equity portfolio or access sophisticated alternative investments may feel like they’re stuck.
And the way some see it, if bond prices are at or near to what’s believed to be their upper price limit, this makes not owning them a relatively low-risk bet under such circumstances. But, things can change so quickly in the markets that this needs to be carefully considered for each investor to determine whether the potential risks outweigh the potential gains of such an approach.
What do rising rates mean for bond investors?
The reason rising rates and the corresponding low yields cause problems for investors is that those low yields mean the funding needs of institutional investors (typically the biggest bond buyers) aren’t met. The interest rates are just too low for pension funds, insurance companies, and sovereign wealth funds to satisfy their financial needs with these investments.
These big investors can’t change the asset mix or risk profile overnight, so holding bonds essentially forces them to fail to meet their obligations.
For individual investors, low rates make the payouts from these bonds lower than the return expectations built into their retirement plans. This leads investors to chase yield or go out the risk spectrum in search of incremental returns.
A persistent rise in interest rates and bond yields could also mean investors move away from bond funds and ETFs — in taxable accounts anyways – and move toward a renewed preference to own bonds directly.
How do portfolio managers mitigate these risks in bond funds?
Back when yields had been dropping steadily for 40 years, some bond managers found being short their duration benchmark to be a career-limiting move.
As markets start to move away from the COVID recession, in 2021, it seems that some are inevitably going to learn the hard way that if yields rise steadily for a protracted period, the mistake will be maintaining duration at or longer than the benchmark.
In a rising rate environment, it generally makes sense to invest in bonds with shorter terms to maturity – also referred to as lower duration – because they are less sensitive to rate changes.
Fixed income managers can also invest in floating-rate notes (FRNs). These debt instruments have a variable interest rate that is tied to a known benchmark rate. Floating rate notes or floaters can be issued by financial institutions, governments, and corporations, with maturities of up to five years.
It’s not all bad news for bondholders if you think long term
The coronavirus pandemic quickly ushered in an acute global recession. A year in, bond markets seemed to have finally recognized that it was not a normal recession.
But, rising rates don’t have to mean only bad news for bond investors. In the short run, rising interest rates negatively affect the value of a bond portfolio because the existing inventory of bonds fall in price relative to newer issue ones.
Over the longer term, however, rising interest rates can actually increase a bond portfolio’s overall return. This is because the proceeds of maturing bonds are able to be reinvested into new bonds that offer higher yields. Investors can also reinvest their coupon payments into higher-yielding fixed income securities.
Most investors are investing for retirement, so a long-term focus is key. Yes, the short term can be painful, but patience is key in all market environments.
“The single greatest edge an investor can have is a long-term orientation.”Seth Klarman