Notes, Views, and the Occasional Provocation June / July 2013 

When my youngest son asked what I was writing about recently and I said, "Bonds," he got excited, thinking I said "Bombs," and mimicked the sound of a huge explosion. A lot of bond investors feel the same way these days, worrying that a shift to higher interest rates will decimate their fixed-income holdings.

While interest rates remain the primary drivers of bond returns, the relationship between rates and bonds is not nearly as straightforward as it might seem. Historical evidence suggests that bonds will continue to make a valuable contribution to investment portfolios even in rising interest-rate environments.

Best Regards,

Milo Benningfield

How Bond Investors Miss the Forest for the Trees
Bond theory tells us that bond prices should fall when interest rates rise. But theory offers little help in deciding whether bonds still make sense for portfolios today. more

BFA Media Quotes
Recent media quotes. more

How Bond Investors Miss the Forest for the Trees
Driving into Tuolumne Meadows, high above Yosemite Valley, is a breathtaking experience. In summer's early evening, sunlight slants through tall pines, falling on a vast green field and meandering river. If you're like me and know little about nature's complex ecosystems, you might imagine that the meadow has always looked this way, a beautiful complement of trees and grass in perfect, timeless harmony.

The meadow is anything but static, however, and the trees and grass far from friends. "We don't even know if the meadow will be here in fifty years," our friend Salli the ranger explained, pointing to the lodge pole pines and their seedlings that have encroached on the open space.

For decades, the National Park Service pulled up the seedlings to control tree growth. Then the bark beetles came, carrying a blue-stain fungus that was lethal for the pines. Warmer winters allowed the lodge pole needle miner moth to proliferate, felling more trees. Knowing where to strike the proper balance between trees and meadow became an increasingly complex task as new variables were added to the equation, leading the Park Service to stop its eradication program altogether. "We realized we didn't know what we were doing," Salli said.

The forces at work in the capital markets are every bit as complex as those at work at nature. Yet investors often view them as simplistically as I did the meadow, making major portfolio decisions based on little more than speculation.

The most recent example is last month's bond sell-off, when investors pulled more than $80 billion out of bond funds. The sell-off was sparked by the Federal Reserve's suggestion that it might reduce its bond purchases, designed to suppress interest rates, later this year.

When interest rates rise, bond prices fall, all else being equal. Given this, it's easy to see how future interest rate movements become the source of so much conjecture and why investors might be spooked into selling bonds at the slightest hint of rising rates.

However, at present, we have no reliable models for predicting future rate movements. If we did, "bond king" Bill Gross, famed manager of the Pimco Total Return Bond Fund, would probably have found it. Yet two years ago in 2011, Mr. Gross made what he later admitted was a major miscalculation in betting that interest rates would move against U.S. Treasury bonds and, as a result, caused his fund to fall to the bottom 15% of his bond category that year.

Mr. Gross had lots of distinguished company with his guess on rates that year. In December 2010, when the 10-year Treasury yield was 3.32%, Barron's asked lead economists at top financial institutions to aim their econometric arrows at where they believed rates would be at the end of 2011. Most of them aimed at targets twenty to forty percent above the then-current Treasury rate:

Twelve months later, however, 10-year rates had moved with equal force in the opposite direction, declining to under 2.0%:

2011 was not even a particularly bleak year for the forecasters. In fact, what's surprising when you look at the history of such forecasts isn't the magnitude of the misses, but that anyone tries their hand at all at guessing where rates will go next. The information flows required to tackle the problem are simply too vast for even the most sophisticated computer models to digest.

Even if we could predict rate movements, knowing how they will affect particular bonds is another matter. There are more than a thousand bond issuers and tens of thousands of bonds in which to invest. These bonds vary in numerous respects and respond differently to rate shifts depending on how fast and how far rates move and over what time period. Bond price movements also vary depending on the current state of credit spreads (the difference in yield between more and less creditworthy bonds) and the "term structure of interest rates" (the different yields offered by bonds of shorter and longer maturities).

But perhaps the biggest factor that investors who focus exclusively on interest rates miss is this: even when bond prices fall, the total return offered by bonds may still be positive. How is this possible? Price movements are only one component of a typical bond's total return. The other part is the income stream paid through interest, or "coupons," over time.

Over the past twenty years, we've had three distinct periods when the Federal Reserve raised the Fed Funds target rate over time: a fourteen-month period in 1994-1995, when the Fed raised rates 3%; twelve months in 1999-2000 when rates rose 1.75%, and twenty-five months in 2004 to 2006, when the Fed raised rates 4.25%.

In each of these periods, bond prices fell, as expected, on a diversified basket of intermediate-term bonds. But the total return delivered by these bonds was positive, thanks to interest income that more than offset the price declines:

It's ironic that the income component of bonds is so easily forgotten in most discussions of what rising rates mean for fixed-income investors. Before the days of electronic exchanges, when stock tickers still spit out prices on long strips of paper, investors held bonds primarily for this income and often literally clipped the "coupons" in order to collect their interest payments.

When I got back home from Tuolumne Meadows, I read about how its origins lay with an icefield that melted 15,000 years ago, leaving a bed of sand and silt with poor drainage that was eventually covered by marshes and ponds and then today's grasses and trees. The meadow is ever growing and changing and will be different tomorrow than today. The same can be said for the capital markets, where nothing is ever quite as simple as it seems.

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BFA Media Quotes
The New York Times, June 29, 2013
Milo was quoted in an article by Tara Siegel Bernard, "Taking a Cue From Bernanke a Little Too Far," which discussed bond investors' over-reaction to concerns about rising interest rates. "It's a futile game to base portfolio moves on interest rate guesses," Milo noted, among other observations. "Investors should take a strategic approach designed around the reason they hold bonds—and then sit tight whenever hedge funds and other institutions shake the ground around them." Read the article.

Thank you for reading. Please look for our next newsletter in September.

Best regards,

Milo Benningfield

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