An expectation of higher interest rates is nothing new, as experts have been predicting higher rates for over a decade now. But it appears the wheels may finally be in motion to produce those long-anticipated higher rates. The Federal Reserve finally hiked rates for the first time a year ago and the market is clearly anticipating a second hike this month. And the Trump election win has poured gasoline on the higher-rate expectation fire, given that three of his primary issues (fiscal stimulus, less immigration, and trade protectionism) would be expected to directly contribute to higher rates. And that doesn't even address whether Trump, working with Republican majorities in Congress, will be able to rev up the economy's growth rate with a more business-friendly agenda. If they can, that impact would certainly tilt the field toward higher interest rates as well. Perhaps not surprisingly, then, the 10-year Treasury yield has jumped from 1.88% on Election Day to 2.4% today.
The prospect of higher interest rates has many bond investors feeling fearful. After all, the most fundamental rule to understand regarding bonds is that as bond yields rise, bond prices fall (and vice versa). That's not a prediction or a historical tendency, it's a mathematical fact.
But while bond investors are understandably worried about rising interest rates cutting into their bond principal (via falling bond prices), the news isn't quite as dire as many think. That's because of the rising income dynamic that comes into play as interest rates rise. It's true that on any specific individual bond, the rate is fixed, leaving only the downside of its price falling as rates rise (which only matters if the bond is sold before it matures). But even with an individual bond, the bond owner has the opportunity to reinvest the income that bond is producing in new bonds that are sporting higher yields.
In the context of a bond fund, this dynamic is perhaps easier to see. The existing bonds in the portfolio will decline in value as interest rates rise. But the income being produced is being re-invested in new higher-yielding bonds. Over time, there's a tradeoff between capital losses from the bond principal and higher income from the newer, higher-yielding bonds. That tradeoff doesn't always even out — it's possible for that combination to net out to an overall loss — but it's not the one-sided coin that some bond investors think of when contemplating higher interest rates.
A few years ago, Vanguard founder John Bogle pointed out that the best predictor of future bond returns is actually today's current yield. He noted that since 1926, the entry yield on the 10-year Treasury explained 92% of the annualized return an investor would have earned over the following decade if they held that Treasury to maturity and reinvested the income at prevailing rates. That's not what most bond fund investors are doing, but it's still relevant. Other studies have found similar results. For example, "the entry yield on the Barclays U.S. Aggregate Bond index (of investment-grade U.S. bonds) explains 90% of its 10-year returns for the years 1976 to 2012, says Tony Crescenzi, a portfolio manager and strategist at Pacific Investment Management Co."
Let's take a look at the Vanguard Intermediate-Term Bond Index fund (VBIIX) and see how this comparison has held up recently. Ten years ago, in December of 2006, the 10-year Treasury yield was 4.6%. Today it is just 2.4%. That means the 10-year Treasury yield has roughly fallen by half. Yet the 10-year annualized return on VBIIX has been 5.2%, just a bit better than the starting 10-year Treasury yield a decade ago.
This is something of a double-edged sword for bond investors today. At just 2.4%, today's 10-year Treasury yield doesn't exactly inspire a lot of excitement in terms of the next decade's likely bond returns. But it should be a little reassuring that in spite of the 10-year Treasury yield falling by half over the past decade, the annualized returns of VBIIX didn't move much higher than the starting yield at the beginning of the period. By extension then, it's reasonable to expect that if rates were to double over the next decade, annual returns might be a bit lower than today's starting yield of 2.4%, but probably not as much as some investors fear. If you're thinking rising rates are likely to cause crippling losses in short- and medium-term bonds, that's not likely to be the case.
In fact, the article linked to above points out that in the past, the more sharply rates rose, the wider the divergence between the entry yield and overall returns became — in a positive direction. Due to interest rates spiking in the late-1970s, the annualized returns of bond yields for the decade ending in 1986 came in at 10.5%, despite the starting yield being just 6.8%. So even if interest rates go up sharply from here, for investors who remain invested in bonds, the long-term implications of that aren't necessarily as bad as many fear.
Bottom-line, at least for short- and intermediate-term bonds, yield matters more to long-term returns than what is happening with their capital gains/losses. Rising yields, while painful in the short run, won't necessarily ruin returns for bond investors the way many fear they will. And longer-term, a return to more "normal" interest rate levels is almost certainly a good thing overall, providing the economy can handle the higher levels. Savers in particular have been crushed by the past eight years of unnaturally low interest rates and higher rates would be sweet relief to them. The journey back higher won't necessarily be pleasant, but it may not be quite as rough as many bond investors have been expecting either.