Investing in a Rising Interest-Rate Environment
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Investing in a Rising Interest-Rate Environment
- 1. Investing in a Rising-Interest-Rate Environment Markets Research Team Morningstar © 2013 Morningstar. All Rights Reserved.
- 2. History of Interest Rates January 1926–August 2013 20% 16 12 8 Average: 5.2% 4 4.6% 3.6% Current: 3.4% 1.1% 0.0% 0 Long-term government bonds Intermediate-term government bonds 30-day Treasury bills Past performance is no guarantee of future results. This is for illustrative purposes only and not indicative of any investment. An investment cannot be made directly in an index. © 2013 Morningstar. All Rights Reserved.
- 3. Long-Term Government Bonds’ Downturns and Recoveries January 1926–August 2013 • Expansions • Downturns • Recoveries • Long-term government-bond yield Growth of $1 16% Yield $100 14 12 10 Downturns of 10% and more 8 10 6 4 2 0 1 1926 1936 1946 1956 1966 1976 1986 1996 Past performance is no guarantee of future results. This is for illustrative purposes only and not indicative of any investment. An investment cannot be made directly in an index. © 2013 Morningstar. All Rights Reserved. 2006
- 4. Long-Term Government Bonds’ Downturns and Recoveries January 1926–August 2013 Downturn % Loss 19 months Recovery –10.9% 12 months Jun 1958–Dec 1959 Feb 1967–May 1970 21 months 27 months Jun 1970–Mar 1971 Dec 1972–Aug 1974 40 months Jan 1960–Dec 1960 Sep 1974–Dec 1974 –18.8% 10 months –10.4% 4 months –21.0% 10 months Jul 1979–Sep 1981 13 months Oct 1981–Jul 1982 –10.3% 4 months May 1983–May 1984 Mar 1987–Sep 1987 15 months 2 months Nov 1994–May 1995 Oct 1998–Dec 1999 9 months Oct 1987–Jan 1988 Feb 1994–Oct 1994 7 months Jun 1984–Sep 1984 Jan 2000–Jul 2000 –13.4% 4 months –12.1% 7 months –10.4% 7 months –11.2% 14 months Jun 2003–Jul 2003 12 months Aug 2003–Sep 2004 –14.9% 8 months Jan 2009–Dec 2009 Sep 2010–Jan 2011 13 months Feb 2011–Aug 2011 Aug 2012–Aug 2013 5 months Jan 2010–Aug 2010 TBD –11.4% 7 months –13.2% 15.3 months –13.2% TBD Average Past performance is no guarantee of future results. This is for illustrative purposes only and not indicative of any investment. An investment cannot be made directly in an index. © 2013 Morningstar. All Rights Reserved. 7.9 months
- 5. Intermediate-Term Government Bonds’ Downturns and Recoveries January 1926–August 2013 • Expansions • Downturns • Recoveries • Intermediate-term government-bond yield Growth of $1 18% Yield $100 16 14 12 10 Downturns of 5% and more 10 8 6 4 2 0 1 1926 1936 1946 1956 1966 1976 1986 1996 Past performance is no guarantee of future results. This is for illustrative purposes only and not indicative of any investment. An investment cannot be made directly in an index. © 2013 Morningstar. All Rights Reserved. 2006
- 6. Intermediate-Term Government Bonds’ Downturns and Recoveries January 1926–August 2013 Downturn % Loss Recovery 8 months –5.3% 7 months Jun 1931–Jan 1932 15 months –5.7% 7 months Jun 1958–Aug 1959 8 months 2 months 3 months Sep 1981–Nov 1981 –6.9% 6 months Feb 1994–Nov 1994 11.2 months Mar 1980–Apr 1980 –8.5% Jun 1980–Aug 1981 10 months Sep 1959–Mar 1960 –8.9% Jul 1979–Feb 1980 15 months Feb 1932–Aug 1932 –7.1% Dec 1994–May 1995 Average Past performance is no guarantee of future results. This is for illustrative purposes only and not indicative of any investment. An investment cannot be made directly in an index. © 2013 Morningstar. All Rights Reserved. 5 months
- 7. Investors Have Most of Their Money in Intermediate Bonds As of August 2013 • Short-term bonds • Intermediate-term bonds • Long-term bonds 13% 23% 64% Past performance is no guarantee of future results. This is for illustrative purposes only and not indicative of any investment. An investment cannot be made directly in an index. © 2013 Morningstar. All Rights Reserved.
- 8. Bond Prices Decline for Longer Periods in Low-Interest-Rate Environments Downturns of Long-Term Government Bonds, January 1926–August 2013 25 Average decline (months) 20 15 10 5 0 Below 3% 3%–5% 5%–7% Over 7% Starting bond yields in the beginning of each of the past 25 biggest bond-market declines Past performance is no guarantee of future results. This is for illustrative purposes only and not indicative of any investment. An investment cannot be made directly in an index. © 2013 Morningstar. All Rights Reserved.
- 9. Fund Flows and Asset-Class Performance January 1994–August 2013 • U.S. stocks • International stocks • Bonds Asset-Class Performance 40% Return 20 0 –20 –40 Annual Net Asset Fund Flows $300 billion 200 100 0 –100 –200 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 Past performance is no guarantee of future results. This is for illustrative purposes only and not indicative of any investment. An investment cannot be made directly in an index. © 2013 Morningstar. All Rights Reserved. 10 11 12 Jan– Aug 13
- 10. Annual Net Flows of Noncore-Bond Funds January 2007–August 2013 $50 bil 40 • Bank loan • Emerging markets bond 30 • High-yield corporate bond • Nontraditional bond 20 10 0 –10 –20 2007 2008 2009 2010 2011 2012 Past performance is no guarantee of future results. This is for illustrative purposes only and not indicative of any investment. An investment cannot be made directly in an index. © 2013 Morningstar. All Rights Reserved. 2013 YTD
- 11. Average Performance of Bonds Based on Monthly Interest-Rate Changes January 1926–August 2013 30% • 30-day Treasury bills • Intermediate-term government bonds 20 • Long-term government bonds • Long-term corporate bonds • High-yield corporate bonds 10 0 –10 –20 Rising interest rates Neutral interest rates Falling interest rates Full period return Past performance is no guarantee of future results. This is for illustrative purposes only and not indicative of any investment. An investment cannot be made directly in an index. © 2013 Morningstar. All Rights Reserved.
- 12. Bond Performance in Times of Rising and Falling Interest Rates January 1960–August 2013 5-year government-bond yield Shaded areas represent rising interest rates 20% 15 10 5 0 Long-term government bonds 74.6% Long-term corporate bonds 87.9% High-yield corporate bonds 60.7% 45% 30 15 0 –15 45% 30 15 0 –15 45% 30 15 0 –15 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 Past performance is no guarantee of future results. This is for illustrative purposes only and not indicative of any investment. An investment cannot be made directly in an index. © 2013 Morningstar. All Rights Reserved. 2010
- 13. Corporate Credit Spread and Treasury Yield January 1973–August 2013 18% Yield 7% Credit spread • Intermediate-term corporate A credit spread • Barclays US Government yield index 16 6 14 5 12 4 10 3 8 2 6 QE1 1 4 QE2 QE3 2 0 0 –1 1973 1978 1983 1988 1993 1998 2003 2008 Past performance is no guarantee of future results. This is for illustrative purposes only and not indicative of any investment. An investment cannot be made directly in an index. © 2013 Morningstar. All Rights Reserved. 2013
- 14. Average Performance of Equities Based on Monthly Interest-Rate Changes July 1927–December 2012 20% Dividend size 15 • No dividend • Lowest 30% • Medium 40% • Highest 30% 10 5 0 –5 Rising interest rates Neutral interest rates Falling interest rates Full period return Past performance is no guarantee of future results. This is for illustrative purposes only and not indicative of any investment. An investment cannot be made directly in an index. © 2013 Morningstar. All Rights Reserved.
- 15. Large Stock Dividend Yield Versus 10-Year Treasury Yield January 1871–August 2013 18% • 10-year Treasury yield • Large stock dividend yield 16 14 12 10 8 6 4 2 0 1871 1881 1891 1901 1911 1921 1931 1941 1951 1961 1971 1981 Past performance is no guarantee of future results. This is for illustrative purposes only and not indicative of any investment. An investment cannot be made directly in an index. © 2013 Morningstar. All Rights Reserved. 1991 2001 2011
- 16. Inflation, Not Rising Rates, Biggest Bond Threat in the Long Term Intermediate-Term Government Bonds, January 1926–August 2013 • Nominal performance • Inflation-adjusted performance $100 Bonds Can Deliver Negative Returns on Inflation-Adjusted Basis, 1970–1980 120% 100 80 60 40 20 0 –20 1970 1972 1974 1976 1978 1980 10 Annualized return Nominal 5.3% Inflation-adjusted 2.3% 1 1926 1931 1936 1941 1946 1951 1956 1961 1966 1971 1976 1981 1986 1991 1996 Past performance is no guarantee of future results. This is for illustrative purposes only and not indicative of any investment. An investment cannot be made directly in an index. © 2013 Morningstar. All Rights Reserved. 2001 2006 2011
- 17. Rolling Period Risk and Return January 1926–August 2013 1-year periods (1,041) Positive returns 60% 5-year periods (993) 10-year periods (933) 20-year periods (813) 74.0% 77.8% 78.5% 81.3% 86.9% 94.3% 94.6% 96.2% 94.3% 100.0% 99.9% 100.0% 100.0% 100.0% 100.0% 100.0% 162.9% 108.7% Understanding the Graph Best 5% 50 Other 90% 40 Worst 5% Median Return Most Recent Return 30 20 10 0 –10 –20 –67.6% –48.0% • Large stocks • Portfolio • Long-term government bonds • Long-term corporate bonds Past performance is no guarantee of future results. This is for illustrative purposes only and not indicative of any investment. An investment cannot be made directly in an index. © 2013 Morningstar. All Rights Reserved.
Editor's Notes
- History of Interest Rates This image illustrates the historical characteristics of long-, intermediate-, and short-term interest rates as represented by long-term government bonds, intermediate-term government bonds, and 30-day Treasury bills. Among all three instruments, on average, long-term government bonds delivered the highest yield of 5.2%, while intermediate-term government bonds and 30-day Treasury bills provided an average yield of 4.6% and 3.6%, respectively. More importantly, the most recent interest rates seem to be positioned at relatively low levels, significantly trailing their respective historical averages. As of August 2013, the yields for long-, intermediate-, and short-term Treasuries were 3.4%, 1.1%, and 0.0%, respectively. Long-term government bonds, while having the longest maturity of all three securities, had the narrowest yield oscillation ranging from 1.8% to 14.8% over the entire period. 30-day Treasury bills, on the other hand, had the widest yield range spanning from −0.7% to 17.4%. The graph shows that in rare instances, short-term yields can turn negative for brief periods of time, signifying that investors are occasionally willing to pay the U.S. government to guard their investments during turbulent market environments. Under normal economic circumstances, longer-maturity government bonds should offer higher yields than short-term bills because of inflation expectations and maturity risk. In certain periods, however, when future inflation is expected to decrease substantially, and investors’ confidence plummets causing the drop in demand for short-term borrowing, Treasury bills can offer yields much larger than those of long-term government bonds as was the case between 1980 and 1981. Government bonds and Treasury bills are guaranteed by the full faith and credit of the U.S. government as to the timely payment of principal and interest. U.S. government bonds may be exempt from state taxes and income is taxed as ordinary income in the year received. With government bonds, the investor is a creditor of the government. In general, the price of a debt security tends to fall when interest rates rise and rise when interest rates fall. Securities with longer maturities and mortgage securities can be more sensitive to interest-rate changes. About the Data The long-term government-bond yield is represented by the monthly Ibbotson SBBI U.S. Long-Term Government-Bond Yield Index. The intermediate-term government-bond yield is represented by the monthly Ibbotson SBBI U.S. Intermediate-Term Government-Bond Yield Index. The 30-day Treasury bill yield series uses annualized monthly Ibbotson SBBI U.S. 30-Day Treasury Bill Total Return Index.
- Long-Term Government Bonds’ Downturns and Recoveries Because of their longer maturity and, thus, longer duration, long-term government bonds tend to be highly sensitive to the fluctuations in interest rates. The image illustrates the growth of $1 invested in long-term government bonds in January 1926, along with various periods of downturns and recoveries. A downturn in this chart is defined as the index closing at least 10% down from its previous high close. Its duration is the period from the previous high to the lowest close reached after it has fallen 10% or more. A recovery is measured from the lowest close reached after the index has fallen 10% or more until it recovers all its lost value. An expansion is measured from the recovery point until the next high. This definition of a downturn for long-term government bonds (a drop of 10% or more) was chosen in order to display most of the significant drops in value that occurred over the time period analyzed. In general, for long-term government bonds, 10% is considered a significant loss of value. There have been 12 such downturns since January 1926. A lower threshold for the definition (5%, for example), would have produced 25 downturns, while a threshold of 15% would have produced only 2. Therefore, a definition of a downturn of 10% was decided upon as a reasonable basis for illustrating long-term government bonds downturns and recoveries in this chart. The most recent downturn began in 2012 and is still in progress as of August 2013. In general, longer-maturity fixed-income instruments tend to have more interest-rate risk than their shorter-term equivalents. With that being said, despite all the volatility and the numerous periods of declining prices, long-term government bonds were still able to deliver positive returns over a longer investment horizon. Government bonds and Treasury bills are guaranteed by the full faith and credit of the U.S. government as to the timely payment of principal and interest. U.S. government bonds may be exempt from state taxes and income is taxed as ordinary income in the year received. With government bonds, the investor is a creditor of the government. Debt securities have varying levels of sensitivity to changes in interest rates. In general, the price of a debt security tends to fall when interest rates rise and rise when interest rates fall. Securities with longer maturities and mortgage securities can be more sensitive to interest-rate changes. About the Data The growth of long-term government bonds is represented by the Ibbotson SBBI U.S. Long-Term Government-Bond Total Return Index. The analysis of downturns and recoveries is based on past downturns (January 1926–August 2013) of 10% or more. The long-term government-bond yield is represented by the Ibbotson SBBI U.S. Long-Term Government-Bond Yield Index.
- Long-Term Government Bonds’ Downturns and Recoveries A specific account of the past long-term government-bond market downturns and recoveries can present a better picture of potential market performance in the face of rising interest rates. A downturn in this chart is defined as the index closing at least 10% down from its previous high close. Its duration is the period from the previous high to the lowest close reached after it has fallen 10% or more. A recovery is measured from the lowest close reached after the index has fallen 10% or more until it recovers all its lost value. An expansion is measured from the recovery point until the next high. This definition of a downturn for long-term government bonds (a drop of 10% or more) was chosen in order to display most of the significant drops in value that occurred over the time period analyzed. In general, for long-term government bonds, 10% is considered a significant loss of value. There have been 12 such downturns since January 1926. A lower threshold for the definition (5%, for example), would have produced 25 downturns, while a threshold of 15% would have produced only 2. Therefore, a definition of a downturn of 10% was decided upon as a reasonable basis for illustrating long-term government bonds downturns and recoveries in this chart. The most severe downturn occurred between July 1979 and September 1981 when long-term government-bond prices plummeted 21.0%, and it took the market 27 months to reach its trough. Following the downturn, the recovery period lasted 10 months. Based on the past 12 largest downturns, on average, the long-term government-bond market declined 13.2% and the average decline length was just over 15 months. These severe downturns, however, were usually followed by a period of robust and quick recovery that, on average, occurred within eight months. Government bonds and Treasury bills are guaranteed by the full faith and credit of the U.S. government as to the timely payment of principal and interest. U.S. government bonds may be exempt from state taxes and income is taxed as ordinary income in the year received. With government bonds, the investor is a creditor of the government. Debt securities have varying levels of sensitivity to changes in interest rates. In general, the price of a debt security tends to fall when interest rates rise and rise when interest rates fall. Securities with longer maturities and mortgage securities can be more sensitive to interest-rate changes. About the Data Long-term government bonds are represented by Ibbotson SBBI U.S. Long-Term Government-Bond Total Return Index. The analysis of downturns and recoveries is based on past downturns (January 1926–August 2013) of 10% or more.
- Intermediate-Term Government Bonds’ Downturns and Recoveries Due to shorter maturity and, thus, less sensitivity to the changes in interest rates, intermediate-term government bonds tend to be much less volatile than long-term government bonds. A downturn in this chart is defined as the index closing at least 5% down from its previous high close. Its duration is the period from the previous high to the lowest close reached after it has fallen 5% or more. A recovery is measured from the lowest close reached after the index has fallen 5% or more until it recovers all its lost value. An expansion is measured from the recovery point until the next high. This definition of a downturn for intermediate-term government bonds (a drop of 5% or more) was chosen in order to display most of the significant drops in value that occurred over the time period analyzed. As opposed to long-term government bonds, intermediate-term government bonds did not experience any downturns of 10% or more. Therefore, for purposes of this chart, the downturn definition needed to be changed in order to capture the intermediate-term government downturns that did occur. A lower threshold for the definition (5%) produced five downturns for intermediate-term government bonds, which are illustrated in the chart, which shows the growth of $1 invested in intermediate-term government bonds in January 1926. Government bonds and Treasury bills are guaranteed by the full faith and credit of the U.S. government as to the timely payment of principal and interest. U.S. government bonds may be exempt from state taxes and income is taxed as ordinary income in the year received. With government bonds, the investor is a creditor of the government. Debt securities have varying levels of sensitivity to changes in interest rates. In general, the price of a debt security tends to fall when interest rates rise and rise when interest rates fall. Securities with longer maturities and mortgage securities can be more sensitive to interest-rate changes. About the Data The growth of intermediate-term government bonds is represented by the Ibbotson SBBI U.S. Intermediate-Term Government-Bond Total Return Index. The analysis of downturns and recoveries is based on past downturns (January 1926-August 2013) of 5% or more. The intermediate-term government-bond yield is represented by the Ibbotson SBBI U.S. Intermediate-Term Government-Bond Yield Index.
- Intermediate-Term Government Bonds’ Downturns and Recoveries Compared with long-term government bonds, the historic account of the past downturns and recoveries of intermediate-term government-bond prices appears to indicate major differences between these two markets. First, there were only five downturns of 5% or more in the intermediate-term government-bond market since 1926. Unlike long-term government bonds, the prices of intermediates have never declined by more than 9%. The most severe downturn occurred between July 1979 and August 1959 when intermediate-term government-bond prices declined 8.9%. Based on the past five most severe downturns, on average, intermediate-term government bonds declined 7.1%, and the average decline length was just over 11 months. Following the downturns, the complete recoveries occurred within three to seven months. A downturn in this chart is defined as the index closing at least 5% down from its previous high close. Its duration is the period from the previous high to the lowest close reached after it has fallen 5% or more. A recovery is measured from the lowest close reached after the index has fallen 5% or more until it recovers all its lost value. An expansion is measured from the recovery point until the next high. This definition of a downturn for intermediate-term government bonds (a drop of 5% or more) was chosen in order to display most of the significant drops in value that occurred over the time period analyzed. As opposed to long-term government bonds, intermediate-term government bonds did not experience any downturns of 10% or more. Therefore, for purposes of this chart, the downturn definition needed to be changed in order to capture the intermediate-term government downturns that did occur. A lower threshold for the definition (5%) produced five downturns for intermediate-term government bonds, which are illustrated in the chart. Government bonds and Treasury bills are guaranteed by the full faith and credit of the U.S. government as to the timely payment of principal and interest. U.S. government bonds may be exempt from state taxes and income is taxed as ordinary income in the year received. With government bonds, the investor is a creditor of the government. Debt securities have varying levels of sensitivity to changes in interest rates. In general, the price of a debt security tends to fall when interest rates rise and rise when interest rates fall. Securities with longer maturities and mortgage securities can be more sensitive to interest-rate changes. About the Data Intermediate-term government bonds are represented by the Ibbotson SBBI U.S. Long-Term Government-Bond Total Return Index. The analysis of downturns and recoveries is based on past downturns (January 1926 –August 2013) of 5% or more.
- Investors Have Most of Their Money in Intermediate Bonds Long-term bonds tend to be more sensitive to changes in interest rates than intermediate- and short-term bonds. One reason for this is that investors want to be compensated for the higher risk and uncertainty that come with longer-term investments. Also, when interest rates start climbing, as they have been doing since the beginning of 2013, bonds already on the market have to compete with newer bonds that pay higher coupon rates. A bond with a longer length of time left to maturity would be less attractive to investors, because of these lower coupon payments, than a bond with only a short time left until it matures. As illustrated by the image, investors are aware of all this. As of August 2013, most of the assets allocated to fixed income are placed in intermediate-term bonds (64%), with 23% in short-term bonds and only 13% in long-term bonds. This appears to indicate that most investors are risk-averse and avoid placing too large a share of their assets in long-term (more volatile) bonds. Government bonds and Treasury bills are guaranteed by the full faith and credit of the U.S. government as to the timely payment of principal and interest. U.S. government bonds may be exempt from state taxes and income is taxed as ordinary income in the year received. With government bonds, the investor is a creditor of the government. With corporate bonds, an investor is a creditor of the corporation and the bond is subject to default risk. Corporate bonds are not guaranteed. Only insured municipal bonds are guaranteed as to the timely payment of principal and interest by issuer. However, insurance does not eliminate market risk. A municipal-bond investor is a creditor of the issuing municipality and the bond is subject to default risk. Municipal bonds may be subject to the alternative minimum tax and state and local taxes, and federal taxes would apply to any capital gains distributions. About the Data The chart is constructed based on total net asset data from funds in Morningstar’s database. The analysis includes U.S. open-end mutual funds and exchange-traded funds but excludes money market funds and funds of funds. Data as of August 2013.
- Bond Prices Decline for Longer Periods in Low-Interest-Rate Environments It is well-documented that the duration of a fixed-income security and the magnitude of changes in interest rates can have a significant impact on the security’s price. There is additional observation, however, that can be made with regard to the length of the decline in bond prices when interest rates start to rise. This chart represents the historical relationship between the starting bond yield when bond prices began to decline and the number of months it took to reach the trough of the market. The illustration above was constructed using the past 25 largest downturns in the long-term government-bond market since 1926. Each drawdown duration was grouped based on the bond yield at the beginning of each decline, and average decline length was calculated for each group. As it turns out, the lower the starting bond yield in the beginning of the decline, the longer the bond bear market can persist. For example, when long-term government-bond yields began to rise from a below 3% level, the declines lasted for more than 20 months on average. This was true for the bond downturns in 1950 and 1954 when prices declined for 33 and 36 consecutive months, respectively. It is also worth noting that the most recent bond-market drawdown that has begun in July 2012 had a starting yield of 2.1%, and it has already been in progress for 13 months as of August 2013. Government bonds and Treasury bills are guaranteed by the full faith and credit of the U.S. government as to the timely payment of principal and interest. U.S. government bonds may be exempt from state taxes and income is taxed as ordinary income in the year received. With government bonds, the investor is a creditor of the government. Debt securities have varying levels of sensitivity to changes in interest rates. In general, the price of a debt security tends to fall when interest rates rise and rise when interest rates fall. Securities with longer maturities and mortgage securities can be more sensitive to interest-rate changes. About the Data Long-term government bonds are represented by the Ibbotson SBBI U.S. Long-Term Government-Bond Total Return Index. The analysis of downturns is based on past downturns (January 1926–August 2013) of 5% or more. The long-term government-bond yield used in the analysis is represented by the Ibbotson SBBI U.S. Long-Term Government Bond Yield Index.
- Fund Flows and Asset-Class Performance All investors probably wish they had known last year which asset class was going to perform well this year. However, no one can anticipate market movements with such certainty. Investors generally tend to choose asset classes based on past performance, as indicated by the fund flows and asset-class performance charts observed side by side. Flows of money into funds tend to follow performance, a clear example of how investors tend to chase past returns. During the recent financial crisis, investors pulled money out of stock funds for five years in a row. Flows into bond funds, on the contrary, reached a peak in 2009 and remained high in 2010, 2011, and 2012. Fear of the stock-market decline kept investors in flight-for-safety mode even as stocks began to recover. In point of fact, U.S.-stock returns were negative for only one year, 2008. In all the following years, stocks actually posted gains. Now, however, the tables are turned, and expectations of rising interest rates do not bode well for bonds in the near future. Despite these expectations, and negative bond performance in 2013 to boot, flows into bond funds still remained positive, although not nearly as high as they had been in previous years. Diversification does not eliminate the risk of experiencing investment losses. Government bonds are guaranteed by the full faith and credit of the U.S. government as to the timely payment of principal and interest, while stocks are not guaranteed and have been more volatile than the other asset classes. International investments involve special risks such as fluctuations in currency, foreign taxation, economic and political risks, liquidity risks, and differences in accounting and financial standards. About the Data Source: U.S. large stocks—S&P 500® Index, which is an unmanaged group of securities and considered to be representative of the U.S. stock market in general. International stocks—Morgan Stanley Capital International (MSCI) world ex-U.S. index. Bonds—Ibbotson SBBI U.S. Long-Term Government-Bond Total Return Index. Annual Net Asset Fund Flows: U.S.-domiciled fund flows from Morningstar. Start date of 1994 constrained by data availability. The analysis includes U.S. open-end mutual funds and exchange-traded funds but excludes money market funds and funds of funds. Data as of August 2013. U.S. stock: funds that primarily invest in U.S. stocks; International stock: funds that invest in specific regions or a diversified mix of international stocks with 40% or more in foreign stocks; Bond: taxable-bond funds (government, corporate, international, emerging markets, high yield, multisector) that invest primarily in fixed-income securities of varying maturities.
- Annual Net Flows of Noncore-Bond Funds A very attractive characteristic of fixed-income instruments is the income they pay. However, because of the low-interest-rate environment in the past few years, investors haven’t been seeing much income from traditional bonds. The search for higher yields led to more-aggressive allocations and increased flows into emerging-markets and high-yield bonds in 2010, 2011, and 2012. In 2013, however, these categories began to cool off because of the rising popularity of bank-loan and nontraditional-bond funds. Bank loans are syndicated loans made to below-investment-grade companies, and their primary difference from bonds is that they pay coupons at a floating, as opposed to a fixed, rate. This explains the significant jump in flows into this asset class in 2013. Expecting interest rates to go up and, thus, put fixed-coupon, traditional bonds at a disadvantage, investors have increased allocations to floating-rate instruments, such as bank loans. In essence, with bank loans, investors are potentially reducing interest-rate risk but taking on more credit risk. Nontraditional-bond funds also seem to be gaining popularity, due to their ability to short bonds and to potentially perform well even during rising interest rates. Nontraditional-bond funds use a variety of strategies that are normally off limits to traditional funds aimed at profiting from the differences in price movements among bonds. These funds, as well as bank-loan funds, attracted considerable investor assets in 2013. However, it should be noted that nontraditional-bond funds are a new category without significant performance history, and it is difficult to predict how they will perform in a rising-interest-rate environment. International bonds are not guaranteed. With international bonds, the investor is a creditor of a foreign government or corporation. International investments involve special risks such as fluctuations in currency, foreign taxation, economic and political risks, liquidity risks, and differences in accounting and financial standards. Emerging-markets investments are more risky than developed-markets investments. High-yield corporate bonds exhibit significantly more risk of default than investment-grade corporate bonds. Bank loans and senior loans are affected by the risks associated with fixed income in general, including interest-rate risk and default risk. They are often noninvestment grade; therefore, the risk of default is high. These securities are also relatively illiquid. Managed products that invest in bank loans/senior debt are often highly leveraged, producing a high risk of return volatility. Nontraditional-bond funds are riskier than a traditional-bond fund but less risky than an equity fund and can utilize riskier investment strategies in order to achieve their investment objective. About the Data The data is based on estimated net flows using Morningstar asset flows analysis from Morningstar’s database. The analysis includes U.S. open-end mutual funds and exchange-traded funds but excludes money market funds and funds of funds. Data as of August 2013.
- Average Performance of Bonds Based on Monthly Interest-Rate Changes This analysis examines how four types of bonds and Treasury bills performed in various interest-rate environments. Monthly changes in the interest rate were tracked since January 1926, then ranked based on direction and magnitude. Periods of rising rates were defined as the top 20% of all 1,051 months. Neutral rates were defined as the middle 60%, and falling rates as the bottom 20%. Returns during the different periods are calculated by averaging the monthly returns and annualizing the monthly average. For example, in the rising-interest-rates period, the returns of intermediate-term government bonds in the top 20% of months were averaged and then annualized to get a negative 8.8%. This analysis is only hypothetical and is not intended to follow bonds over long performance periods. Instead, it is based on monthly changes in interest rates to show the impact of large interest-rate changes on bond prices and is not indicative of long-term trends. Bonds tend to perform poorly in rising-interest-rate environments, and the longer the maturity, the lower the performance. The only exception were Treasury bills, with a small return, but the only positive one. Both intermediate- and long-term government bonds displayed negative returns, with long-term government bonds performing the worst. Corporate bonds also had a negative return that was between intermediate- and long-term government returns. High-yield bonds were the least negative, although negative nonetheless. These bonds tend to be less sensitive to interest-rate movements because they tend to have shorter maturities and carry more credit risk than interest-rate risk. In general, high-yield bond prices tend to be more sensitive to factors such as the financial health of the issuer, the general economic outlook, and corporate earnings, than to fluctuations in interest rates. Government bonds and Treasury bills are guaranteed by the full faith and credit of the U.S. government as to the timely payment of principal and interest. U.S. government bonds may be exempt from state taxes and income is taxed as ordinary income in the year received. With government bonds, the investor is a creditor of the government. With corporate bonds, an investor is a creditor of the corporation and the bond is subject to default risk. Corporate bonds are not guaranteed. High-yield corporate bonds exhibit significantly more risk of default than investment-grade corporate bonds. Debt securities have varying levels of sensitivity to changes in interest rates. In general, the price of a debt security tends to fall when interest rates rise and rise when interest rates fall. Securities with longer maturities and mortgage securities can be more sensitive to interest-rate changes. About the Data 30-day Treasury bills—Ibbotson SBBI U.S. 30-Day Treasury Bill Total Return Index. Intermediate-term government bonds—Ibbotson SBBI U.S. Intermediate-Term Government-Bond Total Return Index. Long-term government bonds—Ibbotson SBBI U.S. Long-Term Government-Bond Total Return Index. Long-term corporate bonds—Ibbotson SBBI U.S. Long-Term Corporate-Bond Total Return Index. High-yield corporate bonds—Barclays U.S. High Yield Corporate Bond Index. The interest rate is represented by the 5-year government-bond yield (the Ibbotson SBBI U.S. Intermediate-Term Government-Bond Yield Index).
- Bond Performance in Times of Rising and Falling Interest Rates Bonds tend to rise when interest rates fall and decline when interest rates rise. When interest rates fall, new bonds issued at these lower interest rates are not as attractive as existing bonds that pay higher coupon rates, thus increasing the value of the already-existing bonds. Conversely, when interest rates rise, new bonds pay more in coupons than already existing bonds, which makes these decrease in value. The image follows the performance of long-term government, long-term corporate, and high-yield U.S. bonds alongside movements in the interest rate since 1960. The inverse relationship between bonds and interest rates can be clearly observed. For example, when rates started dropping in March 1980 after a relatively long upswing, bond prices also shot up immediately, although briefly. More recently, when rates started climbing at the beginning of 2013, bond performance actually fell into negative territory for government and corporate bonds (although, interestingly, not for high-yield bonds). Government bonds are guaranteed by the full faith and credit of the U.S. government as to the timely payment of principal and interest, while corporate and high-yield bonds are not guaranteed. With corporate bonds, an investor is a creditor of the corporation and the bond is subject to default risk. High-yield corporate bonds exhibit significantly more risk of default than investment-grade corporate bonds. About the Data The 5-year government-bond yield is measured by the yield on a 5-year constant maturity U.S. government bond. Long-term government bonds—Ibbotson SBBI U.S. Long-Term Government-Bond Index; long-term corporate bonds—Ibbotson SBBI U.S. Long-Term Corporate-Bond Index; high-yield corporate bonds—Ibbotson SBBI/Barclays U.S. High-Yield Corporate-Bond Index. Start date of 1960 constrained by data availability for the 5-year government-bond yield. Periods of rising and falling rates are identified by a 2.5% or higher change in the 5-year government-bond yield, in either direction. An investment cannot be made directly in an index. The data assumes reinvestment of all income and does not account for taxes or transaction costs.
- Corporate Credit Spread and Treasury Yield The chart represents the relationship between corporate credit spreads and Treasury yields since January 1973. Historically, these two variables appear to have an inverse relationship. As a result, there are many periods when corporate credit spreads and Treasury yields converge. This can be explained by the fact that the spreads tend to tighten during times of economic growth. At the same time, these are also periods when interest rates tend to rise as a result of the improving economy. The inverse relationship between spreads and yield broke after the 2008 financial crisis, as credit spreads began to decline in 2009 but interest rates remained extremely low despite the economic recovery. The distortion of this historical relationship can be largely attributed to the Quantitative Easing measures that were implemented by the Federal Reserve. Historically, the Fed has been able to control only the short-term interest rates. With the introduction of the first round of the massive bond-buying program that began in 2008 (QE1), the Fed has been able to bring down and maintain intermediate- and long-term government yields at artificially low levels in effort to further stimulate the economic recovery. Government bonds and Treasury bills are guaranteed by the full faith and credit of the U.S. government as to the timely payment of principal and interest. U.S. government bonds may be exempt from state taxes and income is taxed as ordinary income in the year received. With government bonds, the investor is a creditor of the government. With corporate bonds an investor is a creditor of the corporation and the bond is subject to default risk. Corporate bonds are not guaranteed. About the Data The intermediate-term corporate A credit spread is represented by the difference between the Barclays US Corporate A Yield Index and Barclays US Government Yield Index. Start date of January 1973 constrained by data availability.
- Average Performance of Equities Based on Monthly Interest-Rate Changes This analysis examines how stocks performed in various interest-rate environments. Stocks were divided into four buckets based on the size of their dividend yield. For example, stocks in the Highest 30% group are stocks with dividend yields in the top 30% of the dividend companies. Monthly changes in the interest rate were tracked since July 1927, then ranked based on direction and magnitude. Periods of rising rates were defined as the top 20% of all 1,025 months. Neutral rates were defined as the middle 60%, and falling rates as the bottom 20%. Returns during the different periods are calculated by averaging the monthly returns and annualizing the monthly average. For example, in the rising-interest-rate period, the returns of no-dividend stocks in the top 20% of months were averaged and then annualized to get a 5.7%. This analysis is only hypothetical and is not intended to follow stocks over long performance periods. Instead, it is based on monthly changes in interest rates to show the impact of large interest-rate changes on stock prices and is not indicative of long-term trends. Dividend stocks were the worst performing during rising interest rates, because they tend to be more similar to bonds (they pay consistent income). When interest rates go up, new bonds are issued that pay the newer, higher rates, and investors may choose to sell their dividend stocks and buy bonds, to try and preserve income while potentially assuming lower risk. On the flip side, however, high-dividend stocks posted the highest returns during periods of neutral and falling rates, as well as for the full time period analyzed. Stocks with higher dividends, while sensitive to interest rates in the short term, delivered the highest month-to-month returns among all equities over the long term. Stocks are not guaranteed and have been more volatile than the other asset classes. Dividends are not guaranteed and are paid solely at the discretion of the stock-issuing company. About the Data The dividend data is from Kenneth R. French Data Library, http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html. Starting date of July 1927 based on data availability.
- Large Stock Dividend Yield Versus 10-Year Treasury Yield The image illustrates the historical relationship between 10-year Treasury yields and large stock dividend yields since 1871. Before 1957, stock dividend yields were much higher than 10-year government-bond yields. This can be explained by the fact that back then investors preferred dividend payouts as a way of compensation for the additional risk of investing in stocks. In the more modern period, this relationship has changed, as stock buybacks become more common way to distribute corporate earnings. Dividend yields decreased substantially, and capital appreciation became a bigger driver of the stock performance. During this time, between 1957 and 2008, 10-year Treasury yields were significantly higher than large stock dividend yields. As a result, bonds become the main engine for steady income generation. After 10-year Treasury rates significantly declined following the 2008 financial crisis, for the first time since 1957, stocks yielded more than 10-year Treasury bonds. Recent rising interest rates, however, have pushed government yields above stock dividends. Stocks are not guaranteed and have been more volatile than the other asset classes. Dividends are not guaranteed and are paid solely at the discretion of the stock-issuing company. Government bonds and Treasury bills are guaranteed by the full faith and credit of the U.S. government as to the timely payment of principal and interest. U.S. government bonds may be exempt from state taxes and income is taxed as ordinary income in the year received. With government bonds, the investor is a creditor of the government. In general, the price of a debt security tends to fall when interest rates rise and rise when interest rates fall. Securities with longer maturities and mortgage securities can be more sensitive to interest-rate changes. About the Data Large Stock Dividend Yield index is represented by monthly S&P Composite Index. 10-Year Treasury Yield is based on the monthly yield of 10-year government bonds. Both indexes are from Robert J. Shiller Data Library (http://www.econ.yale.edu/~shiller/data.htm). These indexes were chosen in order to provide maximum historical data coverage (back to 1871).
- Inflation, not Rising Rates, Biggest Bond Threat in the Long Term Since the beginning of 2013 when rates started to rise, investors have been concerned about a potential decline in bond performance. In general, bonds tend to perform poorly in times of rising interest rates, but by worrying about rates investors may lose sight of an even bigger long-term threat: inflation. Over the long term (since 1926) investors have lost 3% (the difference between 5.3% nominal and 2.3% inflation-adjusted) in return every year to inflation. Compounded over almost 88 years, the difference in ending wealth values is astounding: A $93 nominal value becomes only $7 when adjusted for inflation. Over certain shorter time periods, inflation-adjusted return can even be negative, as illustrated in the inset chart. Annual inflation averaged 7.9% between 1970 and 1980. Because of such high inflation, investors who may have thought they had achieved a decent cumulative return (104%) had actually lost almost 11% on an inflation-adjusted basis. Government bonds are guaranteed by the full faith and credit of the U.S. government as to the timely payment of principal and interest. About the Data Nominal performance of intermediate-term government bonds—Ibbotson SBBI U.S. Intermediate-Term Government-Bond Index, total return. Inflation-adjusted performance of intermediate-term government bonds—Ibbotson SBBI U.S. Intermediate-Term Government-Bond Index, inflation-adjusted return. Inflation—Consumer Price Index. The 1970–80 time period was chosen to provide an example of how bonds can be adversely affected by high inflation. An investment cannot be made directly in an index. The data assumes reinvestment of all income and does not account for taxes or transaction costs.
- Rolling Period Risk and Return Rolling periods are a series of overlapping, consecutive periods of returns (12 months, 60 months, etc.). For example, when examining 12-month rolling periods, the first rolling period is January 1926–December 1926, the second is February 1926–January 1927, and so on. Risk is depicted in the chart by how wide the ranges of return are. The general pattern that can be identified is that large stocks have the widest ranges of return (and thus the highest risk). Bonds have narrower ranges of return than stocks, and the portfolio falls between stocks and bonds. Another pattern that emerges from the chart is that risk (and the probability to lose money) tends to decrease over time. The ranges of return become less and less wide for all asset classes and the portfolio as the holding period increases from one year to 20 years. Over 20-year holding periods, in fact, returns for all asset classes, and the portfolio, were positive. The hypothetical portfolio was created for illustrative purposes only. It is neither a recommendation, nor an actual portfolio. Holding a portfolio of securities for the long term does not ensure a profitable outcome, and investing in securities always involves risk of loss. All income was reinvested and the portfolio was rebalanced every 12 months. Portfolio allocation is as follows: 10% small stocks, 50% large stocks, 20% long-term government bonds, 15% long-term corporate bonds, 5% Treasury bills. Government bonds and Treasury bills are guaranteed by the full faith and credit of the U.S. government as to the timely payment of principal and interest, while stocks are not guaranteed and have been more volatile than other asset classes. Small stocks are more volatile than large stocks and are subject to significant price fluctuations, business risks, and are thinly traded. With corporate bonds an investor is a creditor of the corporation and the bond is subject to default risk. Corporate bonds are not guaranteed. About the Data Large stocks—Standard and Poor’s 90® Index from 1926 through February 1957 and the S&P 500 Index thereafter, which is an unmanaged group of securities and considered to be representative of the U.S. stock market in general. Long-term government bonds—Ibbotson SBBI Long-Term Government-Bond Total Return Index. Long-term corporate bonds—Ibbotson SBBI Long-Term Corporate-Bond Total Return Index. Small stocks—Ibbotson SBBI Small Company Stock Index. Treasury bills—Ibbotson SBBI 30-day U.S. Treasury Bill Total Return Index.