Visuallizing how a rate rise affects bond funds

[Lsbcal]

Just thought I'd mention a small simple spreadsheet tool I created to try to visualize what goes on when rates rise. I just wanted to get a feel for how an intermediate term bond fund and a short term bond fund might react to a rate rise. This might help me to set my expectations with some actual numbers.

The inputs which can be changed for each fund are:
1) the fund duration
2) the fund's current SEC yield
3) the years the rate rise takes to play out

You can see one run of this below. In this chart there are 3 funds. Fund1 and fund2 both have a 5 year ramp of 3% total rise which are shown in the dashed red and dashed green (scale on right). Their outcomes are shown in solid red and solid green (scale on left). The outcomes show the total returns for the holding period. So for example, fund2 (green solid line) ends up at a 12.5% after 7 years of simulation (CAGR = 1.7%). Fund3 (blue dashed and solid lines) is just the same as fund1 but has a quicker ramp of 3 years to get the full 3% rate rise.

The bottom line total returns are shown in the green part of the table. Notice how the outcomes for the short and intermediate funds are quite similar for an identical rate rise. Also we see how a sharper rate rise (compare blue to red lines) could lead to some negative returns in early years but a better outcome over the entire period -- because once we get to the higher rates we get their benefit longer.

Caveats: Nobody knows when the rate rise might occur or how quickly it might go up. Especially for an active bond fund, the duration and holdings risk trade-offs could change over the years. The rates might rise differently for short and intermediate term bonds. And there are more known unknowns as well as (gulp) unknown unknows.

If someone wants to play with this I could send them the Excel file. Just PM me with your email address.

Comments and suggestions welcome.

 

[REWahoo]

I posted this a few days ago but think it worth another look:

For the diversified bond fund, bond index or balanced fund investor, rising interest rates are simply not the looming catastrophe they have been made out to be.

Must Bond Investors Fear Rising Interest Rates?

 

[Lsbcal]

I posted this a few days ago but think it worth another look:

Must Bond Investors Fear Rising Interest Rates?

I'm not suggesting catastrophe or fan the fears of loosing money, just want to set my expectations correctly. So the simulation tool is just an attempt to get dispassionate numbers together.

 

[REWahoo]

I'm not suggesting catastrophe or fan the fears of loosing money, just want to set my expectations correctly. So the simulation tool is just an attempt to get dispassionate numbers together.

+1

Didn't intend to imply you were doing a Chicken Little imitation and didn't read your post that way. Just thought the article was interesting and appropriate to the subject.

 

[Dawg52]

I posted this a few days ago but think it worth another look:

Must Bond Investors Fear Rising Interest Rates?

I fear everything. Pass me another med.

 

[NW-Bound]

I have been doing stronger med. Just learned that Tequila is also good for me. Will add a bottle to the med cabinet.

 

[REWahoo]

I fear everything. Pass me another med.

How's that liver doing?

 

[rbmrtn]

I posted this a few days ago but think it worth another look:

Must Bond Investors Fear Rising Interest Rates?

I read that article as well. The author did state that there was limited data to use as there were only 5 funds that had been around long enough to have seen a rising interest rate cycle. Also 3 of the funds mentioned were hi yield funds which tend act more like stocks than bonds. And what happens if a retiree is living off the dividends instead of reinvesting. I think reinvisting in the bond funds is making up the losses over time.

 

[Huston55]

REW-

Thx for the link; interesting (counterintuitive) results. Makes me a little less anxious about my bond funds. I've pasted the summary below.

-----------------

What lessons should you take away from my research?

History is on the side of bond investors, even in a rising rate environment;
The low historical variability of returns for bonds means past bear markets were much easier on bond buyers than is commonly thought;
Interest rate increases have unfolded gradually;
Since interest rate increases have been slow, rising interest income will outweigh the loss in principal value;
Maturities should be shortened in a rising rate environment;
Bond funds may perform better than individual bonds during rising rates, because of the ability to reinvest funds at progressively higher interest rates;
Diversification across bond issuers, sectors and maturities is vital during a period of rising rates; and
Avoid experimenting with untested products or strategies during rising rates.

 

[NW-Bound]

How's that liver doing?

When that liver's gone, one has nothing left to fear.

 

[Lsbcal]

Just thought I'd post an update to this. I realized that the yield for this tool should be the fund's distribution yield and not the 30 day SEC yield. The numbers then get better and here is the spreadsheet output (I changed the chart display to be more readable):

 

[Gone4Good]

I posted this a few days ago but think it worth another look:

Must Bond Investors Fear Rising Interest Rates?

Good article. I wouldn't worry too much about the small sample size in the study. That bond funds generated positive returns over a 19 year period of rising interest rates isn't really surprising. It's probably easier to see when reminded that bonds pay 100 cents on the dollar at maturity regardless of what interest rates do in the interim. Almost all, if not all, of the bonds these funds owned in 1963 likely matured by 1981 and therefore completely recovered whatever original mark-to-market losses they once reported. Plus they earned their coupon along the way.

Notwithstanding that, today's 1.75% Pen Fed 3-yr CD seems like it offers a far better risk adjusted return opportunity than Vanguard's Total Bond Market Index at 1.59% and a 5.2 year duration. If bond funds were the only game in town I wouldn't stay awake at night worrying about interest rate risk. But as things are, it's hard to see a good reason to take that risk at all.

 

[haha]

In my always humble opinion, this is article does not tell the whole story. It seems to be written to counter the idea that there is risk in bonds at todays interest rates. I don't think it is possible to give a cogent rebuttal to the proposition that there is risk in bonds today that is out of proportion to the interst rates being offered. I can't say anything about those who can with certainty predict that rates will continue to fall. If they are correct, they will make money.

From the article:
"How did investors do during rising interest rates? There is little data. Of the 4,227 taxable bond funds today, only five had an inception date before 1960 (the relevant rising interest rate period). How did these five perform? This may surprise you. The five funds’ average annual return from 1963-1981, a 19-year period when interest rates rose more than threefold, was 4.15%.1. An equal-weighting of the only five taxable-bond funds available then and now, during those 19 years – the worst run-up in interest rate history – would have doubled."

He neglects to mention that this "return” is very similar to the inflation rate at that time. I don't spend time researching things that are mathematical certainties, so I can't say exactly if there was a small real return, no real return, or a real loss. Certainly, there was a real after tax loss, and very likely a nominal after tax loss. By far the best investment during these years was cash.

All you really need to know is duration, or in the case of a bond fund, weighted average duration. If duration iis 5 years, you are a looser up to five years, and if you are re-investing interest coupons, you should be a winner after five years. So if you are a corporation like a life insurance company, or an immortal being who can be sure of being an essentially perpetual bond investor, adding new money regularly, invest in bonds. If you are a human, who might die, or have needs for the money, either say in cash or if you are a good credit analyst, look for special situations. Benny's ZIRP is death on fixed income investors, so if he can keep this up, there is not going to be any fixed income return. I would rather get ~1% and still have money if somehow Mr. B cannot suppress rates as long as he wishes.

I wish I had access to some sane money and banking experts. As I walked back from TJ's this evening with my food I was wondering, if it should happen that there would be essentially no demand for treasuries at low rates, could Bernanke just create the money to buy all of an issue? Is the only question how much overall debt the US Treasury can pile up? What if other holders like Japan and China not only do not buy, but begin selling treasuries that they now hold? Can Bernanke just create the money to buy them too? Is the USD exchange rate against these other currencies the only counter to a money perpetual motion machine?

I am a great believer in the "if something can't go on, it won't" principle. But I am not well enough informed to know just how far things could go before reaching the can't go on
stage.

Japan is going to be testing this question with respect to their bond rates and currency; we can observe how that goes. One thing for sure, Japan will not be much of a buyer of US Treasuries going forward.

I do believe that it is not always necessary to know when something will fail, or even if it necessarily will fail. If one is convinced that great risk may be about, then all he needs to do is ask himself if there is corresponding large reward in the investment.

I guess everyone can answer that for himself.


Ha

 

[mathjak107]

im not really sure what the reference is for the rising rates? is it the feds fund rate?

that would make little sense if it is whats being used.

short term movement in rates can mean little against longer term rates.

the fed controls short term rates while investors the longer term rates and they don't always see eye to eye.

the famous inverted yield curve was because the fed was pumping up short term rates while investors saw thing differently and pulled longer term rates down.

if the article is pitting short term rates against longer term bond moves the articles not comparing apples to apples.

show us what happens to bond returns when investors bid up longer term rates. that would be apples to apples.

 

[Lsbcal]

I was hoping to get some specific thoughts on modeling a rate rise.

If I wanted to look at a recent rate rise and what actually happened, I'd look at the rise in rates from about March 2004 to May 2006. This was a net 2.2% rise for the 5 year Treasury. Some CAGR's for this 2+ year period are:

VFSUX 1.9% (VG short term investment grade)
VBIRX 1.0% (VG short term index)
VBTLX 1.7% (VG total bond market)
PTTRX 2.4% (Pimco Total Return)

...and after this period the intermediate bond funds (VBTLX and PTTRX) naturally did better then the short term ones because of a higher duration. But, of course, rates were a lot higher then and so the returns were better during that rate rise then one that might occur in the future.

Note the OP was about how one might do a simple model to get at the affect of a rate rise on bond funds we might be in now. Since a good portion of my portfolio has short and intermediate term bonds funds, that is really interesting to me.

There are some smart investors here. And yes, I'm trying to flatter you. Maybe you guys could put your thoughts down on this model?

P.S. I should have mentioned that the equation I use for month to month total return in the spreadsheet model is:

return = yield^(1/12) + rate_rise * duration

where:
yield = the fund's distribution yield
rate_rise = the monthly rate change
duration = the fund's average duration

 

[audreyh1]

Hi Lsbcal

I think the 2003-2006 period is probably a reasonable model. During that period, (ultra) short-term bonds were hit hard, but intermediate term bonds did OK as long-term interest rates actually did not rise. I suspect the next one may be worse, since we are starting from even lower interest rates, but I also suspect will be more gradual and drawn out giving funds more time to recover. The reason I think this is because I don't think the economy will be robust enough for anything but the most gradual of raises. But what do I know?

Personally, I'm not going to worry about it. If interest rates stay low for a few more years, which I think they will, I'll be drawing from my appreciated bond funds (assuming the stock market doesn't have a big rally in the next couple of years). When interest rates rise and depress my bond fund value, I'll be drawing from my stock funds and probably adding to my bond funds too when stocks do well. Part of my sanguinity is because I have owned these bond funds since 2000, so I have been through a cycle already and have benefited from the recent appreciation.

 

[Gone4Good]

I don't spend time researching things that are mathematical certainties, so I can't say exactly if there was a small real return, no real return, or a real loss. Certainly, there was a real after tax loss, and very likely a nominal after tax loss. By far the best investment during these years was cash.

Over the 19 year period in question the CPI index grew at a CAGR of 6.1%, meaning that each of the bond funds mentioned generated real losses.

Meanwhile the simple average (not compounded) interest rate for T-Bills during the same period was 6.3%, so cash was certainly better than bonds.

Of course you mention Japan, where interest rates went down and stayed down for 20 years and counting. In their world, bonds beat cash. What the future holds for us

 

[thefinancebuff]

Notwithstanding that, today's 1.75% Pen Fed 3-yr CD seems like it offers a far better risk adjusted return opportunity than Vanguard's Total Bond Market Index at 1.59% and a 5.2 year duration. If bond funds were the only game in town I wouldn't stay awake at night worrying about interest rate risk. But as things are, it's hard to see a good reason to take that risk at all.

+1. Too many articles are written as if bonds are the only game in town. They also mix the initial loss with the eventual higher income as if one must suffer from the principal loss in order to get the higher income. Not true when you have the option to buy CDs.

 

[haha]

Over the 19 year period in question the CPI index grew at a CAGR of 6.1%, meaning that each of the bond funds mentioned generated real losses.

Meanwhile the simple average (not compounded) interest rate for T-Bills during the same period was 6.3%, so cash was certainly better than bonds.

Of course you mention Japan, where interest rates went down and stayed down for 20 years and counting. In their world, bonds beat cash. What the future holds for us

Thanks for the data about the big inflation of the 70s. Your point about Japan is very well stated. Who would have predicted this? As to the future, I think that all this sovereign borrowing likely has limits, and furthermore that Japan at least is coming very close to the endgame. Once that happens it should become fairly clear that we are not far behind. So, IMO cash will trump- not some money fund perhaps, but short term CDs. It may also be that gold or real productive assets will be better this time.

The way I see it, we now have Mr. Bernanke as King Canute, commanding the seas not to rise in a high tide. When the water rose anyway, King canute recognized his folly, and moved to higher ground. Still tbd is how it works out for Mr. Bernanke.

Ha

 

[mathjak107]

+1. Too many articles are written as if bonds are the only game in town. They also mix the initial loss with the eventual higher income as if one must suffer from the principal loss in order to get the higher income. Not true when you have the option to buy CDs.

staying the course and making up the loss with higher interest only works with the most high grade stuff. everything else has credit risk attached and as credit risk changes so do prices. you may never ever see yourself whole no matter how long you wait.
most of he time your always behind the curve in a rising rate scenerio.

 

[Khufu]

I am not persuaded that interest rates will rise any time soon. Those who think rates will go up seem to me to be underestimating the likely recovery times of an economy that has received a shock of the magnitude of 2008. The fact that rates are low now is not a reason to expect them to rise soon. Just the opposite. The bond market is predicting them to remain low or go lower. While the bond market can be wrong just like any other market, the belief that rates have no place else to go but up is hardly persuasive, especially considering the counter-example of Japan. To me that expectation just reflects a habit of thought, not based on data.

 

[audreyh1]

I am not persuaded that interest rates will rise any time soon. Those who think rates will go up seem to me to be underestimating the likely recovery times of an economy that has received a shock of the magnitude of 2008. The fact that rates are low now is not a reason to expect them to rise soon. Just the opposite. The bond market is predicting them to remain low or go lower. While the bond market can be wrong just like any other market, the belief that rates have no place else to go but up is hardly persuasive, especially considering the counter-example of Japan. To me that expectation just reflects a habit of thought, not based on data.

Khufu brings up an essential point.

Over on M* capecod occasionally updates us on what the futures predict about the Fed Funds Rate: End Q3 Market.-based Rate Predictions

What if the Fed doesn't start tightening until Q4 2015 - almost 3 years from now?
Fed funds rate 1% Dec 2016
Fed funds rate 2% Q4 2018
Fed funds rate 3% sometime after June 2022

That's a long drawn out process.

 

[rbmrtn]

I think the article misses one important point, the fact that reinvesting the dividends is what gave the bond fund their gains during the inflation years, So what happens to the retiree that is living off the dividends ? Looking at just price chart and not total return, some of the bond fund lost 60% + of their NAV, just as bad or worse than stocks ( and never really recovered )

I'm in the rates will not rise soon camp. Still have high unemployment,no demand for the money, the japan scenario looks plausible. hoisington research has been mentioned here, they have some interesting comments on rates and inflation, Economic Overview

I was also thing about what the current energy revolution might do for future inflation, I read some studies that say the US can become energy independent by 2025. If so that tames a major component of inflation. Most of the 70s inflation was energy related.

 

[foxfirev5]

Great info. I plan to hang on to my bond funds although I'm a little short on the duration end. I believe those that promote these funds as a way to offset volatility in equities as well as provide income. My expectations for income from these funds is very conservative for the next 8-10 years. If interest rates do start to rise at a good clip,for an extended period, reinvesting the dividends will be the only way not to lose out.
Through the ups and downs of the last 30 years I have felt comfortable with my understanding of equities. Not so much with bond funds. But since I can't purchase CD's or individual bonds in my current retirement accounts the bond funds are my only option. I'm sticking to 45/40/15 equity/bond funds/cash. We'll see how it works out.

 

[pb4uski]

I'm still mulling over using Guggenheim Bulletshares with various maturities in lieu of bond funds. While the fair value will take the same hit as a bond fund if rates decline, I "think" the structure would outperform bond funds in a rising interest rate environment. That said, I don't expect interest rates to increase in the next year or two so I'm in no hurry to act.