If you follow interest rates, you may have noticed that the 10-year Treasury note recently closed above 3.00% first time since December 31, 2013. So, what does this mean to you?
Let’s start by noting that bond yields rise when bond prices drop. So, when the yield on the 10-year Treasury goes up that means investors are selling them. Why? Investors see inflation building in the economy and, consequently, they anticipate that the Federal Reserve plans to continue to raise interest rates. When interest rates rise, bonds decline in value. The longer the maturity of the bond, the greater the price drop. So, investors are bailing out of the 10-year Treasury, because they do not want to get stuck with losses and they anticipate they will be able to invest in other, newly-issued bonds with higher yields.
The 10-year Treasury is considered a benchmark interest rate. Other interest rates are set in reference to it. As the yield on the 10-year Treasury has risen, so too have other interest rates. This is good news for bond investors. It really has not been possible to earn a meaningful return in high-quality bonds for many years. Interest rates have been persistently low. To illustrate the point, the average annual return over the past 10 years for Vanguard’s Short-Term Bond ETF (ticker symbol: BSV) has been 2.02%. This is just slightly greater than the average annual rate of inflation for the same period (1.7%) (source: Labor Department’s Bureau of Labor Statistics).
The problem, however, is how to invest in bonds while interest rates are rising and not lose money. As mentioned, when interest rates rise, the value of existing bonds drops. Yes, these bonds do generate interest payments, and these offset the decline in principal value. And the loss in principal is only “realized” if the bond is sold before maturity. So, investors in individual bonds can hang on to their bonds when interest rates rise. They will receive their interest payments and they will receive the principal when the bond matures.
However, as we have mentioned in previous blog posts, it is impossible for most investors to achieve adequate diversification by investing in individual bonds. It simply requires more money than most individual investors have. The solution is to invest in mutual funds or exchange-traded funds that are professionally managed.
Bond fund investors, though, can lose money, because the value of the bonds in the fund will drop when interest rates go up. The fund will receive income as interest payments on the bond holdings are received. However, at least “on paper,” the fund may be losing money.
How do bond fund investors manage this principal risk in a rising rate environment? They must keep the length of maturity of the bonds (or duration) short. The longer the average maturity of the bonds in a fund, the greater will be the loss of value when interest rates go up.
We, at Springwater, have been migrating our clients from short term funds (which have very short average maturities) to “floating rate” bond funds that have extremely short maturities. We will come back to the subject of these funds in a future post.
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