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Why rising interest rates don’t mean bonds will lose you money

01 August 2014

The imminent raising of rates is seen by many as the final nail in the coffin of the 30-year bull market in bonds, but experts say investors will still be able to make money from them.

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A diversified portfolio of bonds is a compelling strategy no matter the rate environment, according to Vanguard Asset Management, warning that investors selling down their bond exposure in favour of equities could be exposing themselves to too much risk.

Fears of rising rates have left many investors concerned that their fixed income portfolio is poised for significant loses over the next several years.

However, while rising interest rates can mute the performance of bonds over short time horizons, the impact of rising rates is often misunderstood, Vanguard says.

The firm points out that the impact of rising rates has already been priced into many parts of the fixed interest market, adding that the income being paid out by bonds will help to mitigate against rising yields.

“While many may be concerned about the risk of a capital loss, it is important to consider any investment from the perspective of total return,” said a Vanguard white paper.

“An investor’s actual experience is a combination of both price and income return; focusing on just one can often be misleading.”

To illustrate this point, below is the return of a constant 10-year gilt investment, displaying the future return that would be realised based on the expectation of rising interest rates.

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Source: Vanguard

“A simple duration analysis can give a rough estimate of the price return, but this ignores the income that an investor earns over time,” said Vanguard.

“As the graph shows, despite realising a -10.4 per cent price return over the next 10 years, the investor’s cumulative total return is actually positive at 31.4 per cent.”

“On an annualised basis, this is 2.8 per cent per year, roughly equal to the current yield on the 10-year gilt, which emphasises that the starting yield is key in forming forward-looking return expectations in fixed income.”

“Clearly, just focusing on capital losses ignores the bigger picture.”

Short-duration bonds are less interest-rate sensitive than those with a longer duration, and many investors are currently hiding in them to offset rising yields.

Vanguard warns against such a strategy, believing it doesn’t always give investors the effect they might expect.

Instead, Vanguard recommends that investors hold a more diversified portfolio from a maturities perspective.

“Since short-duration bonds are less exposed to interest rate risk, so the argument goes, the negative impact of rising interest rates on returns will be lessened by moving into cash or reducing duration. While useful for rough estimates, this type of simple duration analysis ignores several key points,” said the paper.

“Firstly, a parallel shift of the yield curve, where yields of all maturities shift equally, is a simplistic view of how interest rates will evolve over time.”

“Moreover, an upward sloping yield curve generally indicates that markets are already expecting interest rates to increase, meaning there are no 'free lunches' in duration tilts.”

Diversifying duration is the key for investors, says Vanguard.

While longer duration bonds have more price risk, the yields on offer are more attractive, thus making them just as attractive, and sometimes more so, from a total return perspective.

“Rates can end up higher or lower, but using duration tilts to benefit from interest rate movements can ignore the role of market expectations and the importance of total returns,” the paper said.

“The implications of duration tilts need to be evaluated within the context of their impact on the overall portfolio.”

“Specifically, we argue that short duration tilts have the advantage of lessening the risk of increased volatility associated with interest rate changes, but potentially at the expense of lessening the portfolio-diversifying properties of long-duration bonds in the face of equity market falls.”

“Overall, we view a broadly diversified bond investment with exposure across the maturity spectrum as a good starting point for the majority of bond investors, and one that can provide diversification to the movement of interest rates across the yield curve in any interest rate environment.”

This article was written in collaboration with and is sponsored by Vanguard Asset Management. 

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