Do Not Be Fearful Of The Fed Rate Hikes, Keep Your Bonds

The Federal Reserve has been increasing interest rates over the past 6 months. Because of this, a lot of investors are getting nervous about investing in bonds. They fear that rising interest rates will lead to a decline in bond prices. In this article, I hope to dispel this fear and encourage investors to continue investing in bonds as they have in other interest rate environments.

The Case Against Bonds In A Rising Interest Rate Environment

The Federal Reserve cut interest rates sharply during the 2008 financial crisis and subsequently poured money into the economy (quantitative easing) until 2014. As the economy has recovered from the recession, the Federal Reserve is now motivated to increase interest rates in the coming years. The Federal Reserve increased rates by 0.25% in December 2016 and by another 0.25% in March 2017, to its current rate of 1.00%. The Fed is planning for more rate increases in the coming years. In December 2016, the Federal Reserve’s interest rate forecast was 1.38% in 2017, 2.13% in 2018, and 2.88% in 2019. There is no doubt that interest rates are expected to rise in the coming years.

With this expectation, there has been a flood of questions on the Bogleheads forums asking whether they should reduce their bond asset allocation in a rising interest rate environment:

1. June 23, 2015: Reducing BND before rate increases
2. November 25, 2016: Bond Funds when Rates Rise?
3. January 18, 2017: Fed Rate [may go] to 3% – [investing consequences?]
4. March 14, 2017: Question about interest rates and bond funds

The Efficient Market Hypothesis Applies to The Bond Market, Too

While not on the radars of most retail investors, the bond market is massive. The size of the global bond market is over $80 trillion dollars, and the size of the U.S. bond market is over $30 trillion dollars. At most investment banks, the bond market trading team is larger than the stock market trading team. A lot of money is made and lost in the bond market on Wall Street.

It is well-known that it is challenging, if not impossible, to consistently beat the stock market. The number and sophistication of stock market participants ensures that stocks are priced correctly, making it very difficult to make above-market returns. Similarly, given the trillions of dollars in the bond market and the sophistication of the traders at the investment banks and hedge funds, making above-market returns in the bond market is no easy matter, either.

Imagine how easy it would be to trade bonds if you could just look at the consensus interest rate forecasts for trading guidance. You would sell bonds when interest rates are expected to rise and buy bonds when the interest rates are expected to fall. Everyone would do it.

But remember that every trade has a buyer and a seller. If you want to sell your bonds, why would anyone buy the bonds from you, if the price was certain to fall when the Federal Reserve raised rates in the coming years? They would not. They would demand a lower price for the bonds to take into account the fact that the Federal Reserve will raise rates in the coming years. This is precisely what happens. Current bond prices have already baked in the expected rate hikes.

Current Bond Prices Are Based On The Yield Curve, Which Is Built On Interest Rate Expectations

Consider the following (very) simplified example. You would like to purchase a 2-year Treasury bond. It is currently paying a 1.25% interest rate, or yield. You could also purchase a 1-year Treasury bond that pays a 1.00% yield. The interest rates of bonds with different maturity dates (i.e. 1-year, 2-year, 10-year, or 30-year) can be plotted on a graph, called the yield curve. This is the yield curve in April 2017:

The yields of these two bonds imply that the market is expecting interest rates to rise by approximately 0.5% in the next year. Why? Because to own Treasury bonds for two years, you could either:

1. Purchase a 2-year Treasury bond, or,
2. Purchase a 1-year Treasury bond, and then buy another 1-year Treasury bond in a year

You should be able to make the same amount of interest in either scenario. This means the expected interest rate in 1 year should be 1.50%, and you would earn 2.50% interest over 2 years:

1. Buy a 2-year Treasury rate: 1.25% / year x 2 years = 2.50% interest
2. Buy a 1-year Treasury today, then buy another 1-year Treasury in a year: 1.00% + 1.50% = 2.50% interest

The current yields on the 1-year and 2-year Treasury bonds show that the bond market already knows that the Federal Reserve will raise interest rates in the next year.

The market took into account the expected increase in interest rates long before the Federal Reserve began actually increasing rates. Future movements in the bond market will not be based on known expected Federal Reserve interest rate increases. It will be based on if the Federal Reserve does more or fewer interest rate increases than they are current planning.

Can You Predict The Future?

Let us assume that you reduced your bond allocation based on the expectation that the Federal Reserve will increase interest rates in the next year. What if the economy were to go into recession this year? Certainly the Federal Reserve would stop increasing interest rates. While the Federal Reserve may not choose to decrease interest rates, keeping interest rates the same when they were previously expected to rise will cause bond prices to go up.

On the other hand, if Janet Yellen begins to use language in speeches that they plan to accelerate the pace of interest rate increases, then bonds will underperform.

We simply do not know which of these two scenarios will happen. Your guess is as good as mine. Market timing is just as hard in bonds as it is for stocks.

Conclusion

Bond prices are based on current interest rate expectations. All known expected interest rate changes (i.e. the Federal Reserve will increase interest rates in the coming years) are baked into current bond prices. Future bond prices will be based on whether the current interest rate expectations are or are not met, as well as what future interest rate expectations will be. Do not be fearful about the Federal Reserve raising interest rates. I am not changing my bond allocation. Neither should you.

What do you think? Have you adjusted your bond asset allocation because of the Federal Reserve’s planned rate hikes?