The Role of Bonds in a Portfolio During a Period of Rising Interest Rates

As a result of a summer of discontent in the fixed income area, many have questions about the role of bonds in the future, specifically whether a period of rising interest rates suggests doom for a portfolio that contains bonds.  The short answer is absolutely not.  A long term plan’s broad asset allocation to bonds should not change simply because one believes interest rates have begun a secular rise due to the fact that bonds are not a monolithic investment category where the question of owning them is a binary yes or no.

A look at the dynamics of the fixed income market explains why.  Any investment has two components of return to an investor:  income and capital appreciation.

Sometimes the income portion is zero (commodities, zero coupon bonds, a subset of common stocks, etc.) or very small (as with another subset of common stocks), in which case the investment is made with the goal of capital appreciation.

Sometimes the income and capital appreciation are more balanced (yet another subset of common stocks, REITs, etc.) in which case capital appreciation is generally more muted.

And sometimes income is the primary component of return while capital appreciation is expected to be relatively small, as with most fixed income securities most of the time.

During secular periods of rising interest rates, as last happened in the United States from 1950 through 1981, the income portion of returns for fixed income securities was easy to obtain while capital appreciation and maintaining purchasing power was difficult due to rising inflation.  This was especially true in the last six or seven years of that period when inflation rose significantly and quite abnormally into double digits.

Conversely, during secular periods of falling interest rates, such as that period from 1981 until perhaps very recently in the United States, the income portion of returns became more difficult to obtain while capital appreciation became unusually easy.

Thus, bond strategies should be very different during a secular rise of interest rates versus a secular decline of interest rates.  Specifically, generating rising income becomes the emphasis and capital appreciation becomes minor if at all.  Usually the strategy involves lowering the duration (a measure of bond sensitivity to interest rate changes), primarily by shortening the maturity of bonds so that when they come due the principal is reinvested into higher-yielding bonds.  As interest rates rise, the new bonds provide more income.  This should greatly please all those pundits who have bitterly complained and whined and moaned about low income from investments.  And as long as serious inflation does not rear its ugly head, maintaining purchasing power does not have to be an overwhelming feat.

Therefore, investors should still maintain their broad exposure to bonds and only adjust their tactical strategy.

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