The past is unlikely to be repeated, but exposure to credit-sensitive and inflation-hedging sectors could minimize rising-rate damage.
Note: This article originally appeared in the December/January 2014 issue of MorningstarAdvisor magazine. To subscribe, please call 1-800-384-4000.
With the 10-year Treasury yield hovering around 3% and last spring's rout still fresh in investors' minds, conventional wisdom seems to hold that higher rates will decimate bond prices. But does history bear that out?
In this article, we review historical interest rate and performance data to evaluate the impact rising rates have had on the bond market in years past under a variety of conditions. We then discuss the strategies we believe will be most effective in protecting capital if and when interest rates move higher.
To conduct our analysis, we compile yield and return data for the Ibbotson Associates SBBI Intermediate-Term Government Bond Index covering every month from January 1946 through September 2013. Using that data, we pinpoint consecutive multimonth periods in which yields rose more than 10 basis points and then calculate the index's total return during those periods.
We choose the Ibbotson index for a few reasons. First, we are trying to isolate the impact of rate changes spurred by rising real yields and evolving inflationary expectations, not widening credit spreads, making a government bond benchmark most suitable. Second, the index targets a five-year maturity, which makes it a rough proxy for the interest-rate sensitivity of "core" portfolios. Third, the Ibbotson index extends back nearly seven decades, a track record that's particularly useful given the different interest rate regimes seen in the post-World War II period.
We find there were 64 multimonth periods in which the Ibbotson index's yield climbed more than 10 basis points. The magnitude of rate increases range from a minimum of just 16 basis points to a maximum of more than 468 basis points, with a median increase of 94 basis points. Similarly, the rising-rate periods vary significantly in terms of length, ranging from as little as two months to as many as 21 months, with a median length of about five months.
Despite popular belief to the contrary, rising rates are not an albatross for the Ibbotson index's performance, at least when viewed in a certain light. Indeed, when we sort by return, we find the index ekes out a nominal return of 22 basis points during these periods, which is hardly the bloodbath some might have expected.
However, some important caveats apply. For one, there is a pretty wide disparity of returns, ranging from a 5.53% cumulative nominal loss (September 1993 to December 1994 when rates rose 297 basis points) to a 5.87% cumulative nominal gain (November 1976 to June 1978, when rates rose 250 basis points). In addition, the median after-inflation return is nothing to write home about--a 1.49% cumulative loss. In other words, rising-rate periods aren't interchangeable--we find a bond investor's experience could differ significantly based on factors specific to the rising-period concerned, such as the level of prevailing yields and inflation.