As inflation was tamed and interest rates descended from an eye-popping 15.8% in 1981, the value of high-yielding investment-grade bonds increased dramatically. Today, with yields at 2.85% there is little upside remaining. In fact, many would argue there is much more downside to bonds than upside.
With such a long, steady fixed-income bull market, it is easy to forget bonds can lose money, especially when interest rates change. In 2018, the Barclays Aggregate Bond Index is down -1.62% through June 30th.
Duration Risk
The unfortunate reality is that the relationship between bond values and yields works in reverse: rising interest rates decreases the values of bonds. Duration measures the sensitivity of a bond’s price to changes in interest rates. With a current duration of 5.29 (Morningstar category average: Intermediate Term Bonds, 6/30/2018), the typical bond fund is very susceptible to capital losses should interest rates rise from their current 2.85% to the historical average over the last 40 years of 6.25%.
Those relying on bonds for downside protection or protection for their often irreplaceable capital might be in for a rude shock.
Rethinking Fixed Income
Previously bond holders were able to have their cake and eat it too. They received both income when yields were higher. Bonds provided not only capital preservation when equity markets sold off, but capital appreciation when yields fell. With the current state of bonds the way it is, investors must choose between yield or protection. They cannot have both.
This forces investors and advisors to rethink how they invest for income and manage market risk and what it means for their long term financial plans going forward. Instead of relying solely on bonds, many may have to look to alternative funds or strategies to fulfill the two roles bonds have done in the past.
Marc Odo is the Director of Investment Solutions at Swan Global Investments, a participant in the ETF Strategist Channel.