US Videos

Rise in Rates Not Always Bad for Bond Investors

Jason Stipp

Jason Stipp: I'm Jason Stipp for Morningstar. After some hiccups in 2013, bond fund investors have come back to bonds as the ever-imminent rise in interest rates has not yet materialized.

Here to offer some perspective on the bond market is Josh Barrickman, head of bond indexing for Vanguard.

Josh, thanks for joining me today.

Josh Barrickman: Thank you. My pleasure.

Stipp: Investors who have been worried for so long about a rise in interest rates must be tired of being worried, because rates have--except for a couple of instances--stayed pretty low and seem like they're stuck there at least for the short to intermediate-term. So, how should investors think about this--investors who are worried about it--given that rates seem so unpredictable? We feel like they have to go up, but they just haven't gone up.

Barrickman: That's just it; I think you touched on it. It's unpredictability. We've said for the last five years that rates have nowhere to go but up, and like you said, except for a 2013 hiccup, we've seen positive bond returns. This just re-emphasizes the point that it's a very difficult thing to do to predict interest rates. We recommend a long-term discipline, stick to your asset allocation, and things will play out well for you.

Stipp: Investors who are looking for more strategic exposure to bonds could consider a fund like the Vanguard Total Bond Market Index, which you manage. How might a fund like that, which has very broad exposure but also some interesting characteristics, perform in different types of environments? What should you know if you were going to buy the index?

Barrickman: The Total Bond Market is benchmarked to the Barclays U.S. Agg, which is composed of Treasuries, mortgages, credit securities, as well as some other securitized products. It has a duration of about five-and-half years, which is going to measure its sensitivity to changes in interest rates. So, for a 100 basis point rise in interest rates, you could expect maybe a 5.5% decline in the price return that you would get in a fund like that. That's of course going to be offset somewhat by the income that's also inherent.

I think what we have to keep in mind, though, is that a rise in interest rates is really not always a bad thing for investors. If you have a long time horizon, a time horizon that's longer than the duration of the fund--so in this case, five-and-half years--you actually benefit from interest rates going up, because you can reinvest at higher and higher yields and earn that interest to recoup some short-term losses.

Stipp: The index overall actually looks different than a lot of the funds in the same category. What kind of bets do you think active managers are taking that have caused them to look different than how the index looks?

Read Full Transcript

Barrickman: It has a lot to do with the credit exposure. Since the financial crisis in 2009 and going forward, you've been able to really load your portfolio up on credit or CMBS or other spread products and do really well, as we've had the Fed be extremely accommodative and really just forecast to the market that you can keep these bets on for a long period of time and earn the carry and potentially earn some spread compression. So, active managers have taken advantage of the fact that, in this environment of a very benign and very transparent Fed, they can feel comfortable taking some spread bets.

Stipp: And clearly, investors have felt comfortable doing that as well, because we've seen some of those areas of the bond market receive a lot of investor inflows. If you are an investor who has taken on more credit risk in your bond portfolio because you've been enticed by those yields, what do you need to know about how that could change the complexion or the composure of your portfolio?

Barrickman: The further you go out on the credit spectrum, whether it's from [investment grade] credit out to high-yield, you start to lose some of that diversification benefit that you think about with your bonds. When you have bonds in your portfolio, it's generally to act as a ballast against your equity volatility. When you start to go out to high-yield, now you have a product that's going to act a lot more like equities; it's not going to be that natural offset to an equity down-trade or uptick in volatility.

Stipp: Investors who are in some of these riskier or higher-yielding investments maybe would look back to 2008 to see how those kind of investments could perform in a rocky market. They haven't really seen that kind of environment since then. So, maybe a little bit of complacency in that area.

The last question I have for you is about international bonds. This is another area of the bond market that investors have been interested in. Vanguard has a new fund that invests in international bonds. Can you talk about what those bring to the table for a fixed-income portfolio?

Barrickman: What that really brings to the table is additional diversification. When you're U.S. centric, you're exposed 100% to changes in U.S. interest rates. With something like our new international agg fund, it's the global bond market excluding the USD. So now you have exposure to different yield curves, different inflation dynamics, and it really diversifies an investor away from just purely a U.S.-centric view.

We offer this product on a hedged basis. The currency risk that's inherent with these markets we invest in gets hedged back to the base currency, the U.S. dollar in this sense. So we can offer diversification with pretty low volatility, given that the currency is taken out, and when you put that into a diversified portfolio, it does allow you to sort of move that efficient frontier up to the top left corner.

Stipp: And not having the currency … do you think that's something investors should think about, something that they would add for additional diversification? What was the thinking behind not having currency exposure in that fund?

Barrickman: When we think about bonds, you're generally investing for stability, again to sort of offset what your equities potentially could do in terms of volatility. When you let the currency remain in that return stream of developed international bonds, you're really upping the volatility to where you have something that looks a lot more like an equity versus what investors are used to in a bond product. So it's really just trying to keep the volatility profile much more fixed-income-like rather than an equity.

Stipp: Josh, thanks so much for your insights on the fixed-income market today.

Barrickman: My pleasure.

Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.