Three Reasons to Own Bonds When the Fed is Raising Interest Rates

Key Points

  • Investors often avoid fixed income investments or move their bond allocations to cash when the Federal Reserve is in the process of raising interest rates. However, that strategy may not produce the best outcome.

  • Avoiding bonds can mean losing out on some or all of the three key benefits of bonds—diversification, capital preservation and steady income.

  • Managing the duration of your bond investments can help mitigate some of the risks associated with Fed tightening.

Investors are often reluctant to invest in bonds when the Federal Reserve is in the midst of hiking short-term interest rates. Why buy bonds now if interest rates—and bond yields—may soon be higher? As bond investors know, rising yields means falling prices.

The short answer: Even in a rising rate environment, bonds can offer three key benefits: diversification, capital preservation and steady income. And just because the Fed is tightening policy doesn’t necessarily mean all bond yields rise.

Fed rate hike cycles have affected bonds differently

Some investors remember 1994-1995 when the federal funds rate doubled in a year’s time and bond prices fell sharply. Similarly, when then-Fed President Ben Bernanke surprised the market in 2013 by suggesting that the Fed might slow the pace of its bond purchases, 10-year Treasury yields jumped by more than 1%—a period known as the “taper tantrum.” 

While these two examples often resonate with investors, the market doesn’t always react to Fed tightening or the threat of it by sending all bond yields higher. The Fed’s influence is greatest on short-term interest rates, but intermediate and long-term bonds may react differently. 

In the 2004-2006 cycle, long-term yields rose before the Fed hiked rates as investors anticipated the changes, but then fell after the actual increase in the fed funds rate began. In the current cycle, 10-year Treasury bond yields have traded in a wide range since the Fed first began to move the federal funds rate above zero in December 2015. Yet despite three rate hikes, bond yields are about where they were when the cycle began. 

The surprise factor

The key difference between the 1994-1995 cycle versus the 2004-2006 cycle (as well as the present cycle that began in 2015) is the surprise factor.  In the first set, the shift in Fed policy was a surprise and the market reacted very quickly by sending yields higher. In 2004-2006 and 2015-present, the Fed signaled its shift in policy ahead of time, allowing market expectations to adjust gradually. 

Consequently, long-term bond funds, which underperformed short and intermediate-term funds during periods when the markets were surprised by Fed policy, actually outperformed when the Fed’s rate hikes were anticipated. 

1994–1995: Rates rose from 3.25% to 6.0% in 13 months

Source: Morningstar Direct, as of 3/31/2017. Cumulative total return by Morningstar bond fund category: short-term, intermediate-term, long-term and multisector. The cumulative total return includes automatic reinvestment of monthly distributions, net of fees. Past performance is no guarantee of future results and the opinions presented cannot be viewed as an indicator of future performance.

2004-2006: Rates rose from 1.25% to 5.25% in 25 months

Source: Morningstar Direct, as of 3/31/2017. Cumulative total return by Morningstar bond fund category: short-term, intermediate-term, long-term and multisector. The cumulative total return includes automatic reinvestment of monthly distributions, net of fees. Past performance is no guarantee of future results and the opinions presented cannot be viewed as an indicator of future performance.

2015–present: Rates rose from 0% to 0.875% in 16 months

Source: Morningstar Direct, as of 3/31/2017. Cumulative total return by Morningstar bond fund category: short-term, intermediate-term, long-term and multisector. The cumulative total return includes automatic reinvestment of monthly distributions, net of fees. Past performance is no guarantee of future results and the opinions presented cannot be viewed as an indicator of future performance.

The federal funds rate is an important benchmark that indirectly affects the financial markets and many consumer rates. Short-term rates are generally most sensitive to changes to the federal funds rate, while longer-term rates are affected more by inflation and economic growth projections.

While it’s tempting to wait for the full cycle of rate hikes to play out, the peak in bond yields may come well before the peak in the federal funds rate.  By tightening monetary policy, the Fed is sending a signal that it is moving toward slowing growth and reducing inflation–two factors that are positive for longer-term bonds.

Diversification from stocks

Having some allocation to bonds also provides valuable diversification from stocks, even when rates are rising. Core bonds—Treasuries, other government securities and investment grade corporate and municipal bonds—tend to have low or even negative correlation with stocks. That can help reduce volatility in a portfolio. However, not all bonds provide diversification. Lower credit quality bonds like high-yield and emerging market bonds tend to be positively correlated with stocks and therefore don’t provide the benefits of diversification.

High credit quality bonds can help diversify a portfolio that includes stocks

Note: Correlation is a statistical measure of how two investments have historically moved in relation to each other, and ranges from -1 to +1. A correlation of 1 indicates a perfect positive correlation, while a correlation of -1 indicates a perfect negative correlation. A correlation of zero means the assets are not correlated. Correlations shown represent an equal-weighted average of the correlations of each asset class with the S&P 500 during the 5-year period between July 2010 and July 2015. Indexes representing the investment types are: Barclays U.S. Aggregate Bond Index (U.S. Agg), Barclays U.S. Treasury Inflation-Protected Securities Index (TIPS), Barclays Municipal Bond Index (Municipals), Barclays U.S. Corporate Bond Index (IG Corporates), Barclays Emerging Market USD Index (USD EM), Merrill Lynch Preferred Stock Fixed Rate Index (Preferreds), Barclays U.S. Corporate High-Yield Bond Index (High-Yield). Diversification strategies do not ensure a profit and do not protect against losses in declining markets.

Source: Bloomberg

Managing duration versus timing the market

We suggest investors manage the duration of their fixed income portfolios rather than trying to time the market.  (Duration measures the sensitivity of a bond’s price to changes in interest rates.) For investors, holding an average duration in the three-to-five year region tends to offer most of the available yield in the market while limiting the potential volatility. If you need some money soon, you can also allocate a portion of your portfolio to shorter-term bonds.

The three-to-five year range  tends to capture the steepest part of the yield curve

Source: Bloomberg as of 4/17/17.

A bond ladder is a relatively simple way to do this. A ladder spreads out the maturities of bonds evenly over time. The bonds at the shorter end of the ladder should be less volatile and offer the flexibility to reinvest at higher yields if rates move up. The bonds in the middle to longer end of the ladder generate income. 

Alternatively, if you hold a portfolio of longer-term bonds, you can shorten the average duration of your portfolio by adding some short-term bonds or floating rate notes. That should reduce the potential volatility associated with rising rates, but not sacrifice as much income and total return as cash investments. 

For bond fund investors, it makes sense to hold funds with different durations–some short-term and some intermediate-term.  Focusing on core bonds—those that are least correlated with stocks—can help maintain diversification in your portfolio, as well. 

If you don’t know the duration of your fixed income portfolio or are unsure how to adjust your holdings, a Schwab financial consultant or fixed income specialist can help guide you in constructing a fixed income portfolio that suits your investment plan.

Next Steps

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Important Disclosures