Bond Funds Can Self-Heal Over Time

This is not to say bonds and bond funds can’t lose money. They certainly can, although the losses tend to pale in comparison to equities. In fact, since 2001, quarterly losses for the Agg have historically foreshadowed a gain over the next 12 months (FIGURE 2).

While it’s true that bond values tend to depreciate as interest rates rise, the opposite can be true for investors whose time horizons extend beyond a bond investment’s normal duration. As each day goes by, and as a bond approaches its maturity, the value of that bond gets closer to par. That’s how a bond’s diminished value can eventually be recouped regardless of future rates—provided the borrower repays the principal.

This “self-healing” feature of bonds may be even more pronounced with bond funds, which typically are highly diversified with hundreds of issuers. As bonds within the fund mature and coupons are paid, the earned interest can then be re-invested in the more recent higher-yielding coupon issues. 

This adds more built-in flexibility to the fund while reducing some of the pressure of having to wait for individual bonds to mature. In this scenario, yields don’t necessarily have to go back down for prices to return to par. Furthermore, given the fact that investment-grade bonds have defaulted at a rate of just 0.10% since 1981 (according to Standard & Poor’s), the best time to invest in bonds could potentially be after a significant rate increase. 

What Constitutes a “High” Level of Rates Might Surprise You

On May 31, 2021, the yield on the 10-Year US Treasury stood at 1.59%—an increase of more than a full percentage point since the August 2020 lows.

It’s true that a 1.59% 10-year US Treasury yield is still relatively low by historical standards, which would suggest we’re in an environment ripe for rates to rise again. That said, some investors may recall that we’ve already seen rates at these levels. 

In fact, current yields are not all that far off from the levels seen when central banks embarked on numerous forms of quantitative easing in the aftermath of the GFC. For example, during the 5-year period from April 30, 2016 to April 30, 2021, the 10-year Treasury averaged 1.98%. The 10-year trailing average for Treasuries was actually a bit higher: 2.10%. 

To be fair, time periods should be looked at individually for the factors that could spark higher rates. In today’s environment, inflation expectations are currently high due to historic stimulus and the unusual phenomenon of fiscal and monetary policy working in unison. That’s a different policy environment from what we experienced after the GFC. So, yes, the potential for higher rates does exist, but we’ve also seen breakevens at this level in the past without sustained higher rates (FIGURE 3). 

Timing Rate Movements Consistently Is Difficult 

While higher rates are always possible, and likely probable at some point, the real problem lies in attempting to time fixed-income purchases based on interest rates. Recent history illustrates just how quickly events can influence the market.

Example 1: In early 2016, the US 10-year Treasury yield stood at 2.27% and finished the year around 2.44%. Just looking at those beginning and ending rates, you might conclude not much happened that year. But in fact, something did. In a referendum in the summer of 2016, voters in the United Kingdom decided to break away from the European Union. The apparent potential for trade disruptions sent 10-year US Treasury yields tumbling dramatically to 1.36%, a midsummer low. By year’s end, yields had fully recovered. 

Example 2: By September 2018, the US Federal Reserve had hiked rates seven times since 2016 and was about to raise them once more in December. By November 2018, the 10-year US Treasury yield reached as high as 3.23%. But by year’s end, the US-China trade war started heating up, and the S&P 500 Index ended the quarter losing more than 13%. After rising for nearly the entire year, the yield in December 2018 proceeded to drop to 2.66% in just over a month. Equity markets eventually recovered in 2019, but yields continued their steady march downward to below 2%—and haven’t been above 2% since August 2019.

Example 3: As 2019 unfolded, US-China trade rhetoric continued to depress yields. By September, the 10-year US Treasury yield stood at 1.46% (FIGURE 4). But a year-end Phase One trade deal between the two superpowers eased tensions and caused yields to spike to 1.90%. That’s also when the first mentions of “coronavirus” surfaced in the news. By March 2020, yields plummeted to 0.50%. So we witnessed rates change from 1.46% to 1.90%, then down to 0.50%—all in a six-month time frame.

The lesson: Attempts at timing the movement of rates have always proven extremely difficult. Random geopolitical events can present unforeseen risks that cause markets to swing wildly, one way or another, in a relatively quick period of time.