Be Not Afraid

It seems all but certain that this week the Federal Reserve Board will raise the Fed Funds target rate at their December meeting. This has led to much hand wringing, fretting and scheming among many investors who own bonds or bond mutual funds.  I have been asked several times in the last month what we should do in anticipation of a higher Fed Funds rate. With such strong telegraphing from the Fed, surely there is some opportunity, no?
The most common question is “Should we get out of bonds now since rates are going up?” The underlying thinking here is that when rates go up, bonds go down, so why would we own something that so obviously is going to lose value?
There’s a few clear problems here. One is assuming that you know something EVERY OTHER INVESTOR doesn’t know. That’s a tough nut. The very fact that it is so “obvious” to most that the Fed is going to raise rates means everyone is expecting it. So if there was some very clear move you should make in anticipation of a 0.25% increase in a bank rate (subtext: be very skeptical of this), everyone would have likely already made it, and the market would have that idea baked in. Trying to make the move a couple of days before the meeting is likely to accomplish nothing.
The second issue is assuming that a higher Fed Funds rate means your bond portfolio is going to lose money, perhaps immediately. It’s this second point I’d like to deflate today.

I’m piggy-backing on some research my friend Ben Carlson did earlier this year in a piece titled “Uncharted Territory in the Fed Funds Rate Cycle.” Ben did the heavy lifting of identifying every rate increase period of the last 50+ years. I’m going to take things a step further and ask a simple question: How did bonds do while rates were going up? Again, the general theory is that bonds should be pretty disappointing in these periods. Rates(/yields) up, prices down. Got it?

Well, here’s the data. I took the dates from Ben’s piece and found the total return (which I then annualized) for the Barclay’s Aggregate Bond index for each period. I annualized returns because the time frames of the rising rate period varied from a few months to a few years and I wanted to try to get a fair approximation of the impact of higher rates.

Start End Period Return Annualized Return
05/1976 06/1976 0.50% 3.02%
05/1977 04/1980 8.15% 2.65%
08/1980 01/1981 -3.25% -6.40%
04/1981 06/1981 -0.34% -1.34%
01/1982 04/1982 6.80% 21.83%
07/1985 12/1985 10.05% 21.10%
04/1988 03/1989 5.16% 5.16%
02/1994 03/1995 0.63% 0.54%
03/1997 01/1998 10.47% 11.47%
07/1999 06/2000 4.56% 4.56%
07/2004 07/2006 7.38% 3.48%

Your first take away should be is that during an overwhelming majority of these rate increases, bond returns were positive. So much for the certainty that Fed rate increases mean poor bond returns. There’s a simple reason for that (well, one reason in a very complex world) which is that the Fed controls short term rates, not the entirety of the bond market (QE aside). Short term and long term rates don’t move in lockstep and it is fairly common for the yield curve to flatten during rate increase periods as short-term rates move up more quickly than long-term rates. (Of course, if it is the central bank’s goal to slow economic growth by raising short-term rates, a flat curve would be the market signaling the Fed’s effectiveness.)

The second takeaway is that your beginning rate effects returns. If you start rising rates from 8%, you’re likely going to get a higher nominal return during the rate increase period than if you start a 1%.

Note that I said nominal return – don’t forget when looking at some of these outsized numbers that there was once a significant inflation problem in the world. Crazy, I know. It is reasonable to have muted expectations about returns during this hike cycle since we are at zero, but probably not live in a constant state of panic. A bit hard to remember, but when the last hiking cycle started we were as low as 1.25%. And even then returns during the hike period (7/04 – 7/06) were an annualized 3.48%.

And so, be not afraid. It’s unlikely that the Fed will go wild raising rates given the overall economic environment and their past track record of moving methodically during rate increases. And it’s unlikely that there would be a 1-1 movement in short and long term rates. And you have a sensible allocation to bonds, right? You don’t just own 30-year zero coupon Treasuries, right? Right? Good. So take a deep breath and finish your holiday shopping.

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