Bonds will lose if rates rise… won’t they?

In Australia, like in other young countries such as Canada and New Zealand, we have had a long love affair with equities. Indeed, Australia has had one of the best performing stock markets in the World over the past hundred years.

This has led us to be equities centric, and whilst we understand stock markets better than most, our understanding of bonds and the bond market is far less developed. Indeed, most Aussies are surprised to learn that the global bond market is roughly tripple the size of the global equity market.

The reverse is true in the older economies of Europe, where stock market investing has been less fruitful and people are generally more risk averse – preferring the security and steady income of bonds to equities.

The general lack of knowledge about bonds in Australia has led to many commonly held views that are basically wrong. One of those common beliefs is that if cash rates rise this will be bad for longer dated bonds (ie will result in capital loss). Whilst losses on bonds are possible in this kind of environment, this outcome is far from certain. In fact, in many cases bonds do not suffer losses at all in rising rate environments.

The missing link and what many investors fail to grasp is that the bond market is constantly anticipating movements in rates and factoring those predictions into bond prices. For example, at the current time we have a positively shaped yield curve which means the bond market is predicting that rates will rise over the months and years ahead.

Put simply, you are only likely to incur a loss on your longer duration bonds if rates rise more rapidly than was expected at the time you purchased your bonds.

The common misconception permeating investment markets at the moment is that if interest rates can only go up from here, then there is little point in holding bonds at all. There are a few points to make in response:

First, it is very hard to forecast interest rates with any consistency. Standard & Poor’s regular scorecard shows most traditional forecast-based managers fail to outpace bond benchmarks over periods of 5 years or more.

Second, there is no guarantee that rates will, in fact, rise any time soon. In the case of Japan, benchmark lending rates have been at or close to zero for 15 years. We have already seen many large bond fund managers make badly timed calls on when the cycle will turn.

Third, bonds behave/perform differently to shares. So regardless of what is happening with the rate cycle, there is a diversification benefit in holding bonds in your portfolio. Diversification is a way of controlling risk and making for a smoother ride.

Finally, if you look at history, it has not always been the case that longer-term bonds will have underperformed shorter-term bonds when short-term interest rates are rising. This is because longer term yields do not move in lock-step with short-term interest rate movements.