First off its interesting to me that so many articles worry about the impact of a rise in interest rates on the bond market but seem to ignore it with regards to its impact on stock prices.
Thus the WSJ article starts out as follows:
"Don't fight the Fed" has been a market mantra for the past four years. But some bond investors are starting to lace on their gloves.
Figuring that the Federal Reserve won't be able to keep a lid on interest rates forever, large money managers such as BlackRock Inc., BLK -0.08% TCW Group Inc. and Pacific Investment Management Co. are getting ready for the day when rates take their first turn higher.
It isn't coming anytime soon, these investors say. But when it does, they worry, the ascent will be swift and steep.
Of course the"don't fight the Fed mantra" is part of stock market lore too. And if there is one thing that pundits endlessly stress in their explanations of the stock markets rise it is the Fed policy of low interest rates which has pushed investors into riskier assets including stocks. In other words there is ample reason to be concerned that a change in interest rate policy will lead to a stock selloff that could be swift and steep as welll. And given that stocks are more volatile than bonds it is the stock market reaction to higher rates that may be more painful.
But back to bond allocations.
- In establishing a bond portfolio it is easier to pinpoint the risk factors and potential risk return of alternative scenarios. While it may not be possible to predict when interest rates will change it is relatively straightforward to predict how various types of bonds will react to changes in interest rates.
- Don't forget the total return: many articles on bonds focus solely on price changes ignoring the total return which is a product of price changes and interest earned.
Despite the many words written on the bond market and the oft repeated warning of a "bond bubble" these same articles are very imprecise in explaining where exactly they see the "bubble" and therefore which bonds are at risk of big losses due to "bubble bursting". I have seen the term applied to high yield bonds, corporate bonds and treasury bonds often with little specificity as to maturity.
So here is an effort at clarity and specificity
Of course bond prices and yields move in opposite directions. And longer term bonds are more sensitive to changes in interest rates than short term bonds. The unprecedented declines in longer term interest rates has led to massive price increases. People have called the rise in prices in long term rates a "bubble" for several years but prices have continued to rise(yields fall).
Unlike stocks which theoretically have unlimited upside bond prices cannot rise forever (interest rates can not fall forever). Therefore it is a simple mathematical certainty that long term bond investors will not experience the total return gains they have experienced in the last years when for example 10 year treasury bond yields fell from over 5% to under 2.5%. Looking further back on the long term chart of bond yields below, it is clear that the gains to holders of bonds over the past decades will not be repeated in the future ...it is simply mathematically impossible, interest rates cannot fall below zero.
So from a strictly mathematical point of view the risk/return to holding longer term bonds is skewed negatively. The downside risk is greater than the upside potential for longer term bonds.
Credit Risk: The other factor affecting bond prices is credit risk i.e. market perception of the potential inability of the issuer to pay back the bond holder. When using ETFs one is investing by asset class therefore diversifying away the individual company risk in the bond portfolio.
Investors can increase their credit risk and increase their yields through moving from treasury bonds to investment grade coporate bonds or even to riskier high yield bonds.
Spreads: the interest rate differential between treasury bonds and coporate bonds of both investment grade and high yield have narrowed at the same time that interest rates have declined. See chart. below.
But are high yield bonds in a "bubble " ? Here is where I think alot of the analysis gets very sloppy. The Federal Reserve has told the world that it will only raise interest rates when economic conditions improve. But when economic conditions improve so should the fortunes of the financially weaker companies that issue high yield bonds. In other words their ability to repay their debt should improve...lowering the risk of default. Remember that in the beginnings of the economic crisis in 2008 as treasury bond interest rates fell, high yield bond interest rates moved up sharply (the spreads increased). Investors in the intermediate term HYG high yield bond ETF suffered a loss of over 17% in 2008 while investors in intermediate term treasury ETF (ITE) had a gain of over 11%.
In other words better economic conditions lead to higher interest rates across the board lead to price changes which are greater as the maturity/duration increases. But there is no reason to assume they will affect high yield (junk) bonds more negatively than Treasury bonds.
Long term bonds may be in a "bubble" or at least have poor risk reward characteristics but it is because of maturity not credit quality.
In other words its the maturity/duration not the credit quality that should be the most important concern in establishing a bond etf portfolio.
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