(PUB) Investing 2015

those monthly income payments instead of reinvesting—well, you shouldn’t really be paying attention to the fund’s price in the first place. Even though rising rates mean the fund’s price is falling, you’ll still own the same number of shares as you always have. Plus, your monthly income is growing as the manager reinvests in higher yielding bonds. Yes, the price will be down, but you’ll be getting more income—which was your goal in the first place. In fact, as your income rises, you have the option of reinvesting your surplus income back into more fund shares at lower prices. Remember, like someone who gets a raise, you have the option to keep spending at higher and higher levels or plowing that raise back into your investments. That’s why I say higher rates are something bond investors should actu- ally look forward to. But I get how counterintuitive that may be, particularly after 35 years of falling yields and rising prices. Plus, the “beware bonds” headlines are only going to heat up as we near a fed funds rate hike. So let’s take this a step further and look at how rising interest rates coupled with reinvested income actu- ally fared in the past. TheTale of theTape First, let’s consider past times the Fed starting increasing interest rates. Since the inception of the Barclay’s U.S. Aggregate Bond Index—a broad measure of the U.S. investment-grade bond market and the index Total Bond Market aims to track—there have been six rising interest-rate cycles. Bonds tended to stumble at first, losing 0.6% on average over the three months fol- lowing the initial rate hike. But the power of reinvesting at higher levels of income started to win out over that initial price decline after about six or nine months. On average, the broad bond index gained 2.4% over the first 12 months after the Fed began raising interest rates. Yes, on average, bonds were up in the year when the Fed started raising rates. Six cycles does not make for an exhaustive study, and each

cycle is different, but it does suggest that a Fed rate hike isn’t an automatic death blow to bonds. For more than three decades we have been in a “bull market” in bonds as generally falling rates have been a tailwind to prices. When investors hear that a bull market is ending, they auto- matically assume that a bear market will ensue. I don’t think that’s going to happen, because I don’t see interest rates rocketing higher. Still, to assuage your concerns, let’s see how bonds performed in the bond bear market of the 1970s. Vanguard’s oldest bond fund, Long-Term Investment-Grade , was launched in July 1973. The chart below shows the growth of a $1,000 invest- ment in Long-Term Investment-Grade at its inception along with the yield on the 10-year Treasury bond over time. When the fund launched, the 10-year Treasury yielded 6.90% and eventually peaked (on a monthly basis) at 15.32% at the end of September 1981 (where the chart ends). Over this roughly eight-year stretch of ris- ing rates, Long-Term Investment-Grade gained 38.1%, or 4.0% a year. It’s fair to say that yields didn’t really start moving higher until the start of 1977, when the 10-year Treasury still sported a yield of 6.87%—essentially the same as when the fund launched. In the nearly five-year stretch from the end of 1976 through the end of September 1981, when yields more than doubled, Long-Term Investment-Grade returned 8.5%, or 1.7% a year. That’s nothing to get excited about, but it also isn’t the

While current yields are near histor- ically low levels, we know they could still go lower. Just look back to July 2012, when the 10-year’s yield fell to around 1.4%. Even at 2.34% yields, a move to 1.0%, which would be signifi- cant, only results in a price increase of 12.1%. Whereas, if interest rates moved toward 4% or 5%, more in line with the 10-year’s average yield over time, today’s bond would see price declines of 15% to 24%. You might say that you expect to hold your bond until it matures, so any price fluctuation is only noise. That’s fine, but I would remind you that if you are buying a 10-year Treasury with a yield of 2.20% (at month’s end), you are locking in that 2.20% return for an entire decade. After considering infla- tion, which is running somewhere close to 2% today, you’ll be earning a negli- gible to negative real return. Investors don’t usually jump on opportunities that offer low future returns with the potential for meaning- ful drawdowns along the way—but that is the reality bond investors face today. The Silver Lining Before you run to hit the sell but- ton, let me explain why I think the media has it wrong—rising interest rates shouldn’t be feared, they should be welcomed by many investors, as they should be a benefit. Let’s say you invest in bond funds for total return and are reinvesting your monthly income distribution each month. As rates rise and prices fall, your reinvested income is actually buy- ing you more shares at lower prices. As you own more shares you get more income each month. On top of that, each share is kicking off more income as the fund manager invests new money (and your reinvested dividend) in high- er yielding bonds. Eventually, though, rates won’t rise any longer. Prices will stabilize. And what you’ll find is that over time those larger monthly income distributions have more than made up for the initial decline in price. If your objective is income rather than total return—that is, you spend

BondsSurvivingaBearMarket

$1,600

17%

Long-Term Investment-Gr. 10-year Treasury Yield

$1,500

15%

$1,400

13%

$1,300

$1,200

11%

$1,100

9%

Treasury Yield

$1,000

7%

$900

$800

5%

Growth of $1,000 in Long-Term Investment-Gr.

9/73

9/74

9/75

9/76

9/77

9/78

9/79

9/80

9/81

The Independent Adviser for Vanguard Investors • August 2015 • 15

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