From August 2020 to late March 2021, the yield on the 10-year US Treasury note increased by more than 100 basis points (1 percentage point). Other government bonds, such as those sold by the United Kingdom and Australia, saw their rates rise as well. Since bond prices decline as interest rates increase and vice versa, some investors are concerned about bond risks in the short term.
IT IS TIME TO HOLD, NOT FOLD
It’s especially important to remember the role bonds play in a diversified investment portfolio during certain market cycles—to act as a shock absorber when stock prices fall.
According to Vanguard study, when global stocks fell by an average of 34% during the global financial crisis, the demand for investment-grade bonds rose by more than 8%. Similarly, from January to March 2020, while equities were at their most volatile due to the COVID-19 pandemic, bonds across the world returned just over 1%, while equities plummeted nearly 16%. When we look at the markets over many entire business cycles, from January 1988 to November 2020, monthly bond returns were positive 71% of the time when monthly equity returns were down.
In other words, don’t let interest rate fluctuations trigger a strategic shift in your bond allocation. During times of increasing rates, myths and assumptions about bond investment prevail, frequently accompanied by demands for dramatic changes to your portfolio. Here are three common investor misconceptions to avoid:
BONDS ARE A BAD IDEA—DON’T FOLLOW THE 60/40 PORTFOLIO
This popular advice undermines the value of maintaining a balanced asset allocation that meets your investment goals, and it may be too late to profit from a tactical asset allocation move. Selling bonds after recent rate hikes, which have lowered prices and total returns, is simply chasing past results. Investors should maintain a forward-thinking attitude: The outlook for bonds is actually stronger now than it was before the rise in yields. Keep in mind that higher yields—and therefore higher interest income—are on the way.
Furthermore, as yields rise, the likelihood of potential capital losses decreases. So now is not the time to stop investing in bonds. On the contrary, as bond yields rise (and prices fall), it becomes increasingly necessary for long-term investors to retain a strategic bond allocation, which might necessitate rebalancing into bonds, rather than the other way around.
ALWAYS CHOOSE CASH, STAY AWAY FROM DURATION RISK
Long-term bonds have been hit the hardest by rising interest rates. However, the advice to minimize period or interest rate risk is retroactive and likely comes too late. Change your perspective on the bond market to one that is more forward-looking. Rates are expected to increase, according to market opinion, and the prices of short-, intermediate-, and long-term issues already reflect this belief. Longer-term bond prices already factor in investors’ expectations of increasing rates, which is why they are cheaper today. If that consensus view turns out to be right, there will be no benefit to switching to shorter-term bonds or assets. Only if longer-term yields grow faster than anticipated will such moves pay off. It’s also possible that yields will grow more slowly than predicted, in which case long-term bonds will perform better.
