Short-Term Pain for Long-Term Gain

Does the 1.34% yield on the 10-year Treasury bond following both Brexit and the election of Donald Trump mark the turning point for a sustained rise in interest rates going forward? No one knows for certain, yours truly included. It’s important to remember that there are thousands, perhaps millions, of interest rates in the world – not alone, monolithic interest rate that the Federal Reserve controls with an iron fist, as is often implied by media coverage. It is notable to recognize that two-year Treasury yields hit a low of 0.15% way back in 2011 (currently 1.3%), and the five-year Treasury yield hit a low of 0.54% in the summer of 2012 (currently 1.9%). That was four to five years before the 10-year Treasury yield hit its low in 2016! The “reach for yield” has been alive the last several years with investors purchasing longer-maturity bonds rather than short-maturity in order to earn a higher yield, despite greater risks with long-maturity bonds.

STOCKS VS. BONDS

Traditionally, by investing in high-quality bonds, investors have made the conscious tradeoff of (1) having a lower risk of principal loss in exchange for lower returns (i.e. yields) relative to stocks, and (2) it was reasonable for investors to expect a modest return above inflation on bonds.
However, these two basic assumptions about investing in fixed income are not so easily taken for granted given the current low starting level of interest rates. With the Fed raising its target rate on short-term Fed funds (borrowing between banks) to a range of 0.75-1.0% in March, we are clearly now on the path back to “normal” interest rates. But with inflation likely to be above 2% in the near-term, we are not fully there yet.

At Trust Company of Oklahoma, we carefully consider the risk of any investment, and in the context of rising interest rates, we consider the primary risk to be a permanent loss of purchasing power from a sustained rise in inflation.

Market participants currently expect the Fed to raise short-term rates twice more in 2017, and continue to raise rates further in 2018 and 2019. Research shows that over the last eight rate-increase cycles from 1958 through 2006, the 10-year Treasury bond on average experienced a total return of -8% over a 15-month period as it adjusted to higher rates. A return of -8% is worth paying attention to, especially for an investment that many hold partly for its stability.

This is best viewed as Short-Term Pain for Long-Term Gain. If interest rates continue to increase further, bond prices may be negatively impacted in the near-term. Yet, so long as an investor’s time horizon is longer than the potential negative short-term impact to bond prices, higher interest rates will benefit an investor’s portfolio as bonds come due and are reinvested at higher rates with all else equal.

Similar to how equity investors need to have at least a 10-to-15-year time horizon to ride out potential stock price volatility, fixed income investors should think similarly when considering bond price volatility.

For example, if a bond investor has a 10-year time horizon before funds are needed, she could invest in a 20-year maturity bond at a fixed interest rate. If inflation and interest rates then increase after purchase, the value of the bond will decline and potentially be sold below the purchase price in ten years, resulting in a loss of principal.

Alternatively, that same investor could purchase a five-year maturity bond at the outset, whose price will be less significantly (and temporarily) impacted if rates increase. She will also receive the benefit of reinvesting at a potentially higher interest rate available at the five-year maturity when the money is reinvested for years six through 10. Not only will the second scenario fully preserve the investor’s principal, but it could potentially earn a higher yield as well, depending on how much market interest rates increased over the investment period.

MANAGING RISK

There are two important investment strategies  TCO recommends to manage the risk embedded in low-interest bonds that currently dominate the market. The first is that we eschew long-term (e.g. 20-30-year maturity) bonds because of the potential price risk given the low starting point of interest rates. At that length of maturity, relatively modest changes in long-term interest rates can have a significantly negative impact on bond prices, which could then take 20-30 years to recover if held to maturity. By investing in short to intermediate maturity bonds, we can more frequently reinvest principal at higher rates, if they were to occur, while forgoing somewhat higher yields available from long-maturity bonds.

Secondly, we recommend not blindly investing in fixed income index funds, which over the last several years have become more heavily weighted in long-term government bonds paying low-interest rates. After the financial crisis, the U.S. and other federal governments issued trillions in additional debt in order to fund huge budget deficits. Subsequently, many trillions of these bonds were purchased by the Federal Reserve via its “quantitative easing” program, in effect buying these bonds no matter the price in order to purposefully drive down interest rates. In addition to the Federal Reserve, large U.S. banks also purchased billions of government bonds, which sit on their balance sheets as liquidity to be available in case another financial crisis were to occur.

Effectively, regulations mandating these piles of liquidity have created more large “non-economic” buyers of low-yielding government bonds. We strongly dislike purchasing an investment in which we compete against big buyers of that investment who frankly don’t care what price they buy or sell. Rather, we prefer to pursue, at minimum, a fair return on our investments considering their risks, not simply whatever return happens to be available.

After everything investors have been through the last 10 years, returning to normal (higher) interest rates, where investors can expect a decent real return, is what we should all hope for. That may mean carefully avoiding unattractive risks and taking short-term pains for longer-term gains.