Interest rates are at record low levels.
The bond market in an almost 40-year year bull market.
It’s very possible you have heard some version of the following statement:
“If (or when) interest rates rise, bonds will lose money.”
If you’re a listener of this retirement podcast, you might know that it’s not entirely incorrect.
Bonds and interest rates do have an inverse relationship.
But it’s complex.
Learn what really happens to a long-term bond portfolio if we enter a rising interest rate environment.
The answer may surprise you!
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Financial Myth #1: If Interest Rates Rise, Bonds Lose Money
Taylor Schulte: Welcome to the Stay Wealthy Podcast. I'm your host, Taylor Schulte, and today I'm starting a four-part mini-series to finish off the year, I'm starting to work on our content calendar for 2020 in an effort to take this show to the next level and make it better than ever.
So in between now and the end of the year, I will be publishing four mini podcast episodes, busting some common myths in the investing and financial planning world. But before we dive in, I just want to take a quick moment to say thank you.
This podcast, this show grew tenfold this year. We went from this small, little hyper-local San Diego-based podcast to this national podcast that broke the top 200 in the iTunes business category earlier this year.
It's just crazy to just say that out loud. I know it sounds kind of cliche, but I really, really could not have done it without you, the listener, your emails, your reviews, your questions, comments, feedback, everything. That's what really keeps me coming back. Every time I think about hitting the pause button on this podcast, I hear from one of you that gives me the motivation that I need to just keep going.
So thank you. Thank you for your support and more importantly, thank you for being a part of this community. As always, you can find the links and resources mentioned in this episode by going to youstaywealthy.com/57.
Okay, so the first myth that I'm busting is extremely timing. Given the current environment with interest rates at record, low levels, and the bond market in this almost 40-year bull market, we often hear some version of the following, if or win interest rates rise, bonds will lose money.
Now, if you've heard this or you've repeated some version of that statement, you might know that it's not entirely incorrect. Bonds and interest rates do have an inverse relationship. In other words, when interest rates rise, bond prices fall and vice versa.
Hence why bonds have been in this bull market since the 1980s when the Fed funds rate hit 16%. Yes, you could buy bonds in the 1980s with double-digit yields. However, if you were a homeowner back then, you knew that your mortgage rate was also in the teens. So since 1981 ish when the Fed funds rate peaked at 16%, interest rates have just fallen dramatically since then.
And as you know now, when interest rates fall, bond prices rise. And to be really clear here, this is not just speculation or historical performance. This is basic math. When interest rates fall, bond prices rise. That's just how bonds work.
In addition to posting a nice chart of this 40-year drop in interest rates, I'm also going to be sharing some resources on the relationship between bonds and interest rates in the show notes if you want to take your learning to the next level. So again, head over to youstaywealthy.com/57 if you want more of what we're talking about today.
Okay, so back to our myth busting. Yes, when and if interest rates rise, bond prices will fall. But here's the kicker. Here's the statement that leads people in the wrong direction. Bond prices will fall in the short term.
So if you're a long-term investor, and yes, that includes all of you that are currently retired and you're likely going to be spending more time in retirement than as a working professional, these short-term movements in the market should not influence you to panic or change your investment strategy.
Remember that bonds serve an important role in your diversified portfolio, especially US government bonds, which I've talked a lot about on this podcast. When stocks drop dramatically, US government bonds typically go up in price.
If you held government, US government bonds through the great recession of 2008, 2009, which all of us remember really, really well, you actually made money owning government bonds through that time period. Investors typically flee to safety.
You might've heard this term, flight to safety. Investors typically flee to safety during catastrophic time periods like ‘08, ‘09, and US government bonds are often viewed as one of the safest asset classes. This also kind of brings up another quick point before we dive into some numbers here. Not all bonds are created equal.
A move in interest rates affects high-yielding junk bonds differently than safe US government bonds. A plain vanilla Vanguard corporate bond fund is going to behave differently than a US government bond fund.
So like everything, make sure you look under the hood to understand exactly what you own and how that investment is correlated with other investments in your portfolio. So to help with today's myth busting, I'm going to reference a friends blog post that he wrote called What is the Worst Case Scenario for Bonds?
And the author is Colin Roche, and his blog can be found at praguecap.com. The name of his blog is Pragmatic Capitalism. So that's short praguecap.com, and I'll link to all this in the show notes for you.
If you're driving or working out at the gym, don't worry about it, just go check out the show notes and everything will be there. In Colin's post, he uses treasury bonds to highlight the worst-case scenario for bonds if interest rates start to rise dramatically from here. So again, if you own corporate bonds or high-yielding junk bonds, the results are going to look a lot different, probably much worse.
And if you don't know what kind of bonds you own, now is probably a really good time to go open up your portfolio, type those tickers into morningstar.com or wherever you do your research and understand exactly what type of bonds you own.
In Colin's example, he assumes that you buy a seven year constant maturity bond portfolio yielding 2% in the very first year. So year one, you buy the seven year constant maturity bond portfolio that yields 2% in the first year, and he uses a seven year maturity bond because it's pretty close to the Barclays aggregate bond index.
So if you own a longer duration bond portfolio, these numbers will not look nearly as friendly. He also is making the assumption that you're buying and holding this portfolio, which isn't entirely realistic because many investors will add money to their portfolio. Some investors will panic and leave the portfolio, or at the very least, an investor stays the course and reinvest their interest payments.
So back to his hypothetical example, he assumes that you buy this seven year constant maturity bond portfolio, which is pretty similar to the Barclays aggregate bond index, and it's yielding 2% in the first year. For his example, each year interest rates are going to rise by 1% until they reach 15% like they did in the eighties.
Now, this might sound really extreme, but again, the title of this post was What's the worst-case scenario for bonds? So you buy this portfolio and every year interest rates are going to rise by 1% until they reach 15%.
As I mentioned at the beginning of the show, we know that bond prices are going to suffer in the short term when interest rates rise in this hypothetical portfolio. And Colin shows us this. In fact, his hypothetical portfolio gets hit really hard at first. In year one, the portfolio is down 4.23%.
So if interest rates rise 1% and you own this portfolio and you just lost 4% of your hard-earned money, you're probably not very happy. But in year two, it drops 3%, so not as bad. In year three, it drops 1.79%, so it's getting a little bit better.
In year four, it's almost flat. And then finally in year five, we have a positive 0.61% return. Now get this, by year nine, we have a positive rate of return of 5.39%, and by year 13, the end of this exercise, the bond portfolio that everyone was just so afraid to own and they were so upset in those first few years, has an annual return of just under 9%.
So how does this work exactly? Well, I'll let you read Colin's entire article if you want to get really nerdy with it. But in short, in increase in interest rates actually starts to have a positive impact on the portfolio because you as the bond holder, are now getting higher coupon payments.
So higher interest rate environment, higher interest rates means you're going to get higher coupon payments and higher coupon payments help to offset the impact of that drop in bond prices. If and when interest rates rise, you're getting more money, more coupon payments in the door because you have a higher interest rate on your bond portfolio.
So if I've just really confused you to help bring us home here, I'm going to read Colin's concluding paragraph where I think he sums it up really well, and he says this, the point of this exercise is to put the risk of bonds and the right perspective. Yes, if rates rise sharply, you'll almost certainly lose purchasing power in your bonds.
However, you will also earn a nominal return better than cash if you hold to maturity. But we should also remember that an aggregate bond portfolio with a constant maturity of about seven years will not necessarily experience traumatic losses.
In fact, even in our worst-case scenario, the seven year bond only declines by a total amount of 9.6% at its low point. In year four. Over the course of our entire 14 years that we held this constant maturity bond portfolio, it actually generated 2.85% per year. So not bad for a worst case scenario.
Before I wrap things up, I just want to highlight that Colin's extreme example really isn't all that extreme. In fact, from 1940 to 1980, interest rates rose from 2% to 15%. So a longer example here, but it happened. And during that time, the 10-year bond, the 10 year T bond, generated an average annual return of 2.85%, which sounds similar to Colin's number. Compound that out over 40 years, an investor who owned a 10-year bond during that 20 year time period more than doubles their money.
So if you want to continue geeking out on bonds and interest rates, head over to youstaywealthy.com/57, and during your holiday parties this year, if you hear anyone talk about interest rates and bonds and that you're going to lose money, maybe you can use that as an opportunity to educate them and let them know that hey, yes, if you're a short-term investor, maybe you shouldn't be investing your money at all, right?
But if you're a long-term investor, and yes, that includes all of you that are currently retired, if you hold your portfolio over a long period of time, it really isn't true. So again, head over to youstaywealthy.com/57 if you want to get more resources on bonds and interest rates and those correlations.
Thank you as always for tuning in, and I'll see you back here in two weeks for myth busting round two.
Hey, it's me again. I just wanted to say thank you one more time for listening and remind you to please, please leave a review. If you're on an iPhone, leave a quick review on iTunes if you're enjoying the show.
I'm getting great feedback from listeners just like you, and I really want to keep the momentum going. So if you have a chance on your iPhone, leave a quick review on the Apple Podcast app. And thank you so much in advance for all of your help and support.
Episode Disclaimer: This podcast is for informational and entertainment purposes only and should not be relied upon as a basis for investment decisions. This podcast is not engaged in rendering legal, financial, or other professional services.