Head Bond investing under a rising rate environment Vanguard Research September December 15 14 Peter Westaway PHD, Todd Schlanger CFA, Savas Kesidis Fears of rising rates has left many investors concerned that their fixed income portfolio is poised for extreme losses over the next several years. However, while rising interest rates can mute the performance of bonds over short time horizons, the impact of rising rates is often misunderstood. In this paper, we emphasise the need to consider the shape of yield curve movement in evaluating the impact of interest rate changes on a bond portfolio, with a particular focus on what type of movement is already priced into bonds today. We also caution investors on implementing short duration strategies, noting that duration tilts can be more nuanced than is often appreciated. We conclude that a broadly diversified bond investment, owning exposure across a range of maturities, remains a compelling strategy for the majority of bond investors in any rate environment. This document is directed at professional investors in the UK only, and should not be distributed to or relied upon by retail investors. It is for educational purposes only and is not a recommendation or solicitation to buy or sell investments. The value of investments, and the income from them, may fall or rise and investors may get back less than they invested.
A bond bear market? Under an expectation for rising interest rates, many investors may be uncomfortable with their bond allocation. While in the long term, yields might provide some certainty with respect to the return an investor earns, with expectations of rising rates, many might argue that bonds are positioned for significant losses in the short to medium term 1. In this section, we will run through a few scenarios for what could happen to bonds under different assumptions to illustrate that not all movements in the yield are the same. An oft-cited justification for such a strategy is the simple textbook analytics of price and duration. This typically assumes a given level shift in interest rates, and uses a portfolio s duration to estimate a price impact. Since short duration bonds are less exposed to interest rate risk, so the argument goes, the negative impact of rising interest rates on returns will be lessened by moving into cash or reducing duration. While useful for rough estimates, this type of simple duration analysis ignores several key points: 1. A parallel shift of the yield curve, where yields of all maturities shift equally, is a simplistic view of how interest rates will evolve over time.. Duration can estimate instantaneous price impact, but investors are best served by considering total returns over time. 3. An upward sloping yield curve generally indicates that markets are already expecting interest rates to increase, meaning there are no free lunches in duration tilts. In evaluating the shape of yield curve shifts, we need some kind of benchmark. Simple duration assumes a parallel shift, but is there an alternative outlook? While interest rates are notoriously difficult to forecast, especially when picking the beginning of a rising rates cycle, a useful exercise in evaluating any duration strategy is to determine what the fixed income market is already expecting for the future movement of yields. In Figure 1, we display the forward curve, which contains the market s expectations for interest rate movement that are already embedded in current bond prices. This is simply a Figure 1. The bond market is pricing expectations of rising rates Market-derived forward gilt yield curves, June 15 4% 3 1 5 1 15 5 Years to Maturity Spot Curve 3 June 15 Implied 3 Year Forward Implied 1 Year Forward Implied 1 Year Forward Implied 5 Year Forward Notes: Spot curve from the Bank of England. Forward curve is derived at an annual frequency, at 1, 3, 5, and 1 year horizons. Sources: Vanguard, based on data from the Bank of England. 1 For additional detail on the role that bonds can play in a portfolio in the context of today s interest rate environment, see Why own bonds when yields are low? (Thomas and Westaway, 13). Specifically, a forward rate is calculated using a combination of current, or spot, interest rates. For example, the 5-year, 5-year forward rate is the market-inferred interest rate of a 5-year bond, 5-years from now. It is derived from the current 1-year and 5-year interest rates. 3 Technically, due to the existence of a term premium for bearing the risk that interest rates do not evolve as expected, the forward curve is not precisely equal to the market expectation. However, it can be viewed as the break-even yield movement where an investor would be indifferent between owning any particular maturity bond over any given time horizon.
derivation of what the marketplace is expecting interest rates to be at some future date, based on where interest rates are today. 3 However, it cannot be overstated that the uncertainty of interest rate movements makes them difficult to time. For example, going into 14, the expectation was for interest rates and bond yields to to rise. However, over the course of the year, yields on 1-year gilts fell by 13 basis points. Figure 1 displays the current spot yield curve, along with the market-inferred future yields curves 1, 3, 5 and 1 years from now. With this information, we can reach two important conclusions. First, the market is already expecting yields to increase. Second, the market is expecting short-term interest rates to increase more than long-term interest rates. This kind of yield curve movement can be roughly described as a bear flattening, with interest rates increasing, but much more at the short end of the yield curve than the long end. Notably, this is substantially different than a parallel shift in interest rates: the yield on the 1-year gilt is expected to increase 115bps while the short term interest rates are expected to go up over 8bps. While this increase has implications for returns, the fact is that a simple duration calculation is unlikely to be a useful predictor in the event that interest rates evolve as the market expects. The forward curve analysis has produced estimates for future yield curve movement, but what about the returns an investor will earn? While many may be concerned about the risk of a capital loss, it is important to consider any investment from the perspective of total return. An investor s actual experience is a combination of both price and income return; focusing on just one can often be misleading. To illustrate this point, we examine the return of a constant 1-year gilt investment in Figure, displaying the future return that would be realised based on the yield curve movement inferred by the forward curve. 4 A simple duration analysis can give a rough estimate of the price return, but this ignores the income that an investor earns over time. As the figure shows, despite realising a -7.15% price return over the next 1 years, the investor s cumulative total return is actually positive at 3.9%. On an annualised basis, this is.17% per year, roughly equal to the current yield on the 1-year gilt, which emphasises that the starting yield is key in forming forward-looking return expectations in fixed income. Clearly, just focusing on capital losses ignores the bigger picture. Figure. A focus on capital loss ignores the total picture The return of a 1-year gilt investment if the forward curve is realised 4% 3 1-1 - Year 1 Year Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 Year 1 Price Return Income Return Total Return Notes: Displays the characteristics of a 1-year gilt investment, assuming the yield curve evolves following the forward curve derived from the June 15 spot curve. Assumes a 1-year gilt is purchased at the beginning of the year, held for 1 year, then sold, with the proceeds re-invested in another 1-year gilt. Sources: Vanguard, based on data from the Bank of England. 4 We assume an investor purchases a 1-year gilt, holds it for one year, and then sells it, reinvesting the proceeds in a new 1-year gilt. This analysis is designed to approximate the performance characteristics of a portfolio, where maturity stays constant. 3
Another point to consider in our look at the forward curve is that, because these interest rate scenarios reflect market expectations, they can be considered break-even yield curves. If these market expectations are realised, an investor earns the same total return ( breaks even ) in any bond investment, regardless of maturity 5. We display this outcome in Figure 3, illustrating the return on a few different gilt investments in the event that the forward curve scenarios from Figure 3 were realised. This result has consequences for any investor considering a strategy that is designed to mitigate the impact of interest rate movement. While the forward curve is a useful tool for framing forwardlooking yield curve movement, it should not be taken as a guaranteed outcome. Indeed, it has rarely been realised precisely over history, and the returns displayed in Figure 3 should be viewed in that context. The important point to take away from this exercise is that positioning a portfolio to avoid rising interest rates isn t enough: one must frame an expectation for rising rates, relative to the interest rate outlook that is already embedded in market prices. An upward-sloping yield curve indicates that the bond market already has factored in some amount of interest rate increases. The higher yields of long-term bonds relative to a cash investment reflect the trade-offs of short-term capital loss versus higher income. A cash investment may reduce the risk of short-term price declines by giving up the term premium, but this comes with an expectation of near-zero percent yield. Because of this, an investor is best served by examining total returns and considering the income that is being given up to avoid a capital loss. The market is already pricing a rising rate outcome, meaning it is difficult to get ahead of any coming rate increase. Figure 3. Yield movement can result in all bonds producing the same return in response to rates Returns of various gilt investments if the forward curve is realised, June 15 Year 1 Year Year 3 Year 4 Year 5 Cumulative 1 Year Gilt Yield Change (bps) 51 49 43 36 9 9 Income Return.5% 1.% 1.5% 1.9%.3% 7.3% Price Return.%.%.%.%.%.% Total Return.5% 1.% 1.5% 1.9%.3% 7.3% 3 Year Gilt Yield Change (bps) 48 43 36 9 3 179 Income Return 1.% 1.5% 1.9%.%.5% 9.4% Price Return -.5% -.5% -.4% -.3% -.3% -1.9% Total Return.5% 1.% 1.5% 1.9%.3% 7.3% 5 Year Gilt Yield Change (bps) 4 36 3 4 18 149 Income Return 1.4% 1.8%.%.5%.7% 11.% Price Return -.9% -.8% -.7% -.6% -.4% -3.5% Total Return.5% 1.% 1.5% 1.9%.3% 7.3% 1 Year Gilt Yield Change (bps) 8 3 18 14 11 94 Income Return.%.4%.7%.9% 3.% 13.9% Price Return -1.7% -1.4% -1.% -.9% -.7% -5.7% Total Return.5% 1.% 1.5% 1.9%.3% 7.3% Notes: Table displays the returns of various gilt investments, assuming the yield curve evolves following the forward curve derived from the June 15 spot curve. Assumes a gilt of the stated maturity is purchased at the beginning of the year, held for 1 year, then sold, with the proceeds re-invested in a bond of the original maturity. Sources: Vanguard, based on data from the Bank of England. 5 As noted earlier, the presence of term premiums might mean that different duration strategies might earn slightly different overall returns. For example, in a typical environment where yields curves are upward-sloping, the term premium would reward long-duration strategies over short-duration. 4
A bear flattening across the pond As we discussed on page 3, an assumption of a parallel shift in the yield curve with a focus on capital loss ignores the upward sloping shape of the yield curve and the market expectations that this shape infers. In fact, during the most recent tightening cycle in the United States starting in 3, the yield curve underwent a bear flattening, not unlike what the forward curve is reflecting today. With stable long-term inflation expectations, the long end of the yield curve stayed relatively anchored. As policymakers began to increase short-term interest rates, a flattening of the yield curve occurred, with short-term rates rising faster than long-term rates. This outcome was more or less in line with what had previously been priced in by the US yield curve, and resulted in bonds of a variety of maturities producing roughly the same total return over the tightening cycle. This experience provides an example of how bear flattening cycles provide an additional nuance to the impact of rising interest rates on bond prices and the difficulty of duration-timing strategies, especially relative to more parallel movements in yields like the period from October 1993 to December 1994 and October 1998 to January, when long-term bonds suffered more significant losses. 6 Figure A : Average annualised return of US treasury investment 1 to 5 year 5 to 1 year 1+ year Oct.1993 to Dec.1994 -.5% -5.% -8.4% Oct.1998 to Jan. 1.4% -3.8% -5.6% May 3 to May 6 1.1%.4%.9% Notes: Figure displays the yield of US Treasury bonds of the stated maturity, from the Federal Reserve, along with the Fed s target for the Federal Funds Rate. Realised return in the table display the return of the corresponding maturity component of the Barclays US Treasury Index, in USD terms, with income re-invested. Source: Vanguard, based on data from the US Federal Reserve and Barclays. Figure A 1. US Treasury Yields Jan.199 to June 15 1% 9 "Traditional" level shifts used to be more typical as inflation expectations were moderating 8 7 6 Bear Flattening occurs when inflation expectations are well anchored 5 4 3 1 199 1995 5 1 15 Fed Funds Rate 3-year 5-year 7-year 1-year 6 For additional details on the US interest rate outlook, see Davis et al. (1). 5
The diversification of duration The forward curve analysis demonstrates that duration tilts may lead to more nuanced outcomes than many might expect. In particular, it is not clear that different maturity investments will lead to different return outcomes, even if interest rates increase, depending on the shape of the yield curve. However, this does not mean that different duration strategies are equivalent in terms of their effects on an investor s overall portfolio. Longer-term bonds tend to exhibit more volatility than a short-term bond investment. This may cause concern for some investors, and lead them to consider a fixed income strategy that removes the interest rate risk of longer-term bonds. However, the implications of any duration tilt need to be considered within the context of a broader portfolio. Before changing the risk characteristics of their fixed income allocation, investors would be wise to examine their broad asset allocation. If the interest rate risk of longer-term bonds is a significant concern, then it is very likely that a significant equity allocation would also carry too much risk for that investor. So rather than implementing a duration strategy as a first step, a more holistic evaluation of an investor s asset allocation may be warranted 7. Assuming an investor is comfortable with their equity allocation, it is important to frame the impact of a bond allocation in the context of the entire portfolio. As we demonstrate in Figure 4, different maturity fixed income investments have different diversification and risk properties when compared to the equity market. When comparing a long versus a short maturity bond investment during the worst equity market outcomes, long maturity bonds have typically tended to provide a better buffer in a portfolio, as demonstrated by the higher median return in the figure. While bonds of all maturities have generally been negatively correlated with equities, longer-term bonds have exhibited larger price moves and so have had a much wider dispersion of outcomes in any environment. This means that, while they have provided moderately better downside protection to an equity allocation in the majority of circumstances, they have a larger degree of uncertainty in any given time period. Investors should keep this finding in mind when evaluating a duration strategy: long duration has typically provided a better buffer to the equity market, but this comes with a higher level of volatility. A reasonable comprise between the trade-offs of short and long duration is to own exposure across the yield curve in a broadly diversified portfolio. Figure 4. Diversification across the duration spectrum Performance of short- versus long-duration government fixed income allocations during the worst equity market outcomes, 1985 15 1 1 8 6 4 - -4-6 Short-Dated Bonds Long Dated Bonds Past performance is not a reliable indicator of future results. Notes: Figure displays the range of outcomes over 3-month time periods, for two maturity segments of the UK government fixed income market, during those 3-month periods when the global equity market has a 5th percentile outcome. Short-dated bonds are defined as the UK 1 to 3 years segment of the Citigroup World Government Bond index, and long dated bonds are defined as the 1+ year segment of the same index. Global equity returns are measured by the MSCI World index. All returns are measured in sterling terms with income reinvested. Figure covers the period Jan. 1985 to June. 15. Source: Vanguard, based on data from Citigroup and MSCI. If an investor is concerned about the impact of rising interest rates on their bond portfolio, previous Vanguard research has shown that global bonds can effectively diversify an investor s existing portfolio of local-issue bonds due to the interest rate diversification. Assuming that the currency risk inherent in a foreign fixed income allocation is hedged back to the investor s home currency, the location the investor is domiciled in has minimal impact on their fixed income allocation. Thus, a more stable return profile can be attained using this method as interest rate movements of many markets can cancel one another out to some extent. It is unlikely that all rates across the world would increase at the same time or with the same magnitude. Global diversification can be a powerful tool for investors in any country or region. 7 For more detail on the benefits of a holistic portfolio approach to investing, see The global case for strategic asset allocation (Wallick, et al. 1). 6
Conclusion: more than meets the eye with rising rates While many generally expect interest rates to increase over time, we have shown that the return outlook for bonds in a rising rate environment may not be nearly as drastic as many simple duration calculations might suggest. While there is tremendous uncertainty with respect to the future path of bond yields, the shape of the yield curve does provide a useful reference point for evaluating the future path of yields. Obviously, rates can end up higher or lower, but we have shown that duration tilts to benefit from interest rate movements can ignore the role of market expectations. It is also important to consider that if rates were to rise, they would eventually lead to higher levels of income and total returns for longterm investors. References Davis, Joseph, Roger Aliaga-Diaz, Donald G Bennyhoff, Andrew J Patterson, Yan Zilbering, 1. Deficits, the Fed, and Rising interest rates: implications for bond investors. Vanguard. https://personal.vanguard.com/pdf/icrdir.pdf Philips, Christopher B., and Charles J. Thomas, 13. Fearful of rising interest rates? Consider a more global bond portfolio. Vanguard. Thomas, Charles and Peter Westaway, 13. Why own bonds when yields are low? Vanguard. (Forthcoming). Wallick, Daniel, Julieann Shanahan, Christos Tasopoulos, 1. The global case for strategic asset allocation. Vanguard. https://personal.vanguard.com/pdf/s34.pdf We have also shown that the implications of duration tilts need to be evaluated within the context of their impact on the overall portfolio. Specifically, we argue that short duration tilts have the advantage of lessening the risk of increased volatility associated with interest rate changes, but potentially at the expense of lessening the portfoliodiversifying properties of long-duration bonds in the face of equity market falls. On average, broader global diversification can be a worthwhile strategy for many investors. And that strategy unlike trying to predict interest rate movements is under every investor s control. Overall, we view a broadly diversified global bond investment with exposure across the maturity spectrum as a good starting point for the majority of bond investors, and one that can provide diversification to the movement of interest rates across the yield curve in any interest rate environment. 7
Connect with Vanguard > global.vanguard.com Important information This document is directed at professional investors in the UK only, and should not be distributed to or relied upon by retail investors. It is for educational purposes only and is not a recommendation or solicitation to buy or sell investments The information on this document does not constitute legal, tax, or investment advice. You must not, therefore, rely on the content of this document when making any investment decisions. The value of investments, and the income from them, may fall or rise and investors may get back less than they invested. Issued by Vanguard Asset Management, Limited which is authorised and regulated in the UK by the Financial Conduct Authority. 15 Vanguard Asset Management, Limited. All rights reserved. VAM-15-1-6-958