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Investing Specialists

The Folly of Predicting the Direction of Interest Rates (and Almost Anything Else)

The past five years are a good illustration of how acting on conventional wisdom can go wrong.

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In early 2010, I wrote an article called "Don't Get Burned by Your Bonds." It was rooted in a common-sense premise. After three decades of declining yields, it seemed that "the easy money" in bonds had been made. Interest rates were apt to go higher at some point, and what had worked well for investors in the past--namely, being willing to take on interest-rate risk--could work against them in the future. The article went on to share some ideas about how to proceed in such an environment, including delegating to an active core bond fund manager and buying dividend-paying stocks with a portion of assets that might otherwise go to bonds.

Some of those recommendations panned out just fine and make sense to me today. I recommended using an active bond fund to navigate what was sure to be a tricky bond market, and three of the four funds on my short list-- Dodge & Cox Income (DODIX),  Metropolitan West Total Return Bond (MWTRX), and  Loomis Sayles Bond (LSBDX)--have performed well over the subsequent five years. ( Harbor Bond (HABDX) has lagged the intermediate-term bond category average and the Barclays Aggregate Index over the past five years, but its shortfall has been small.) And dividend-paying stocks have far outpaced bonds over the past five years. I also suggested that investors avoid taking too much interest-rate risk with assets they expect to spend within the next five years. I'd make that point any time--not just in a period in which rising rates were a threat.

But another point was wide of the mark: that government bonds could prove vulnerable in the years ahead. In fact, the best-performing bond category over the past five years has been the long-term government group, gaining nearly 8%, on average. The short- and intermediate-term government categories have not performed as well in absolute terms; they have also underperformed their short- and intermediate-term general bond counterparts. But that's a typical performance pattern. Because yield constitutes such a big component of bonds' returns, no one should be surprised that the lower-yielding bond types--government bonds--underperformed higher-yielding alternatives like corporates.

The biggest issue with the article, however, was the overarching premise that certain macroeconomic events--specifically, an improving economy that would drive bond yields higher--would materialize, and that investors should rethink their strategies because of it. Such a scenario didn't play out--not at all. Yes, the Federal Reserve did raise short-term interest rates by 0.25% at the end of last year. The Fed's so-called Taper Tantrum--when former Fed chairman Ben Bernanke hinted rate increases could be in the offing--roiled bonds in 2013. But the economy didn't take off with the same strength of previous recoveries in modern history, so yields actually declined over the past five-plus years. When "Don’t Get Burned by Your Bonds" was published in early 2010, the yield on the 10-year Treasury was 3.85%. But that figure soon dropped in half and it has stayed ultra-low. As of this writing, the yield on the 10-year Treasury is just about 1.75%.

I wasn't alone in asserting the thesis that rate-sensitive bond types could be on for tough sledding. Many investors retreated to cash in lieu of bonds, but the net result of that decision was that they've had to settle for ever-lower cash yields. Bond investors have had to make do with lower yields, too, but at least they've had the benefit of price appreciation as yields have slunk lower.

The notion that rates would begin backing up also prompted a spate of new "nontraditional" bond funds about five years ago; many of these products were designed to limit interest-rate risk while taking risks elsewhere, especially in the credit space. (Miriam Sjoblom and Eric Jacobson took a closer look at these funds in this article, and examined performance in this one.) Yet these funds have generally disappointed on the performance front over their fairly short lifetimes: The typical fund in the group has gained just half as much as the Barclays Aggregate Index over the past five years. Moreover, many investors have worsened their own performance by gravitating to these funds at inopportune times. Investors bought nontraditional bond funds hand over fist between 2011 and 2014, and asset inflows into nontraditional bond funds reached their peak in 2013. Unfortunately, they were swapping into these funds just in time for a 2014 rally in the very types of bonds that such funds avoid--high-quality, longer-duration bonds.

Relative to other miscues, the opportunity cost investors have inflicted upon themselves by prematurely playing defense with their bond holdings hasn't been catastrophic. In contrast with the stampede into technology-stock-laden mutual funds in the late 1990s and early 2000, which led to enormous losses, mistiming the rate increase has been small potatoes. Nonetheless, the fact that so many market participants were anticipating events that didn't materialize is yet another humbling example of how difficult it is to predict the future. Rather than casting your lot with a single outcome, it's usually best to diversify your portfolio to accommodate a range of outcomes and focus on factors you can actually control, such as your own savings rate and tax efficiency. It may seem counterintuitive, but admitting what you don't know can actually be one of the best ways to stay on track. 

Christine Benz does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.