With Higher Interest Rates Expected, How Have Bonds Responded?

Last month I discussed the possibility of interest rates rising and the impact it might have on bonds. The article was motivated by a Wall Street Journal survey of 50 top economists who forecasted the yield on the 10-year Treasury bond to rise to 3.47% by the end of 2014. As you may know, the investment return of existing bonds tends to move inversely to interest rates. Consequently, there has been significant concern that bond values are due for a considerable drop, and investors have constantly questioned whether they should reduce their exposure to fixed-income investments.

So how has the economists’ forecast panned out through January? The 10-year Treasury bond began the year at 3.03%, but ended January at 2.65% -- a significant decline. As a result, bonds have generally increased in value. For instance, the iShares Investment Grade Corporate Bond ETF (LQD) is up 1.88% since the New Year, while the iShares Barclays 7-10 Year Treasury Bond (IEF) is up 3.06%. Even the SPDR Barclays International Treasury Bond (BWX) is up .45% in 2014.

What has caused this unexpected result? First, as I noted last month, the historical inaccuracy of interest rate forecasts are well documented. A study by the University of North Carolina found economists predict future rates far less accurately than a random coin flip would fare as a predictor. Rising interest rates have been a general expectation since shortly after the market crash of 2008. Remember all the people who refinanced their homes away from an adjustable-rate mortgage to a fixed mortgage from 2010-2011 out of fear of rising rates? That rate hike still hasn’t come.

But more important than the unpredictable nature of interest rates is the way bond performance has historically been related to the stock market’s performance. In difficult market environments, the investment returns of stocks and bonds tend to have an inverse relationship. In fact, the S&P 500 (a broad measure of the U.S. stock market) has decreased in value during a calendar year five times since 1990 (1990, 2000, 2001, 2002, 2008). In all five instances, the value of U.S. Government Bonds (as measured by the Barclays Long-Term Government Bond Index) has increased (6.29%, 20.28%, 4.34%, 16.99%, and 22.69%, respectively).

How have stocks performed in 2014? The S&P 500 is down -3.46%, the Dow Jones Developed Market ex-U.S. market index (a measure of international stock performance) is down -3.64%, and the iShares MSCI Emerging Markets Index is down -8.63%. It appears investors have fled stocks in a declining market and sought solace in the fixed income benefit that bonds provide, in-step with historic behavioral norms. Of course, higher demand for bonds means higher values. The last month has been a nice reminder of the stability bonds can add to a portfolio in a time of declining stock prices.

While it is reasonable to expect interest rates to rise by some measure over the long-term, it would clearly be a mistake to dramatically shift your asset allocation away from bonds if they were determined to be a part of an investment portfolio that matches your risk tolerance. January illustrated that bonds tend to increase in value and add benefit to a portfolio during market pullbacks, regardless of what interest rates are doing. In fact, bonds’ historical inverse relationship with stocks may be a larger determinate of performance than interest rate expectations.