In response to the very low yield on bonds, some investors have been tempted to chase higher yielding bonds, in an attempt to squeeze some return out of what feels like an unproductive portfolio allocation. This is, unfortunately, an accident waiting to happen. The phrase ‘picking up pennies in front of a steamroller’ comes to mind.
Others are asking whether they should be holding cash as bond yields are ‘inevitably’ going to rise, denting bond returns, at least in the short term. Neither approach makes much sense.
We should be looking forward to yield rises
At some point in the future, yields are likely to rise back to higher levels. The problem is that no-one knows when, how quickly and with what magnitude it will happen. Investors should be looking forward to yield rises, because in the future their bonds will be delivering them a higher yield, hopefully above the rate of inflation.
When yields do rise, bond prices will fall, creating temporary losses. At that point bonds now earn an investor more than they did before the rate rise and they reach a break even point where the new higher yield has fully compensated them for the temporary capital losses suffered. The time to break even is equivalent to the duration (similar to maturity) of an investor’s bond holdings. Short-dated bonds with a three year duration will break even after three years. Below is a hypothetical example. Follow it through.
Table 1‑1: The impact of a 2% rise in yields on a 3 year duration bond portfolio
Note: * We have assumed that the capital loss is approximated by the rise in yields times the duration. In reality due to convexity – capital losses would not be quite so great.
Holding cash deposits is not the solution
Imagine that an investor felt that rate rises were likely to occur, with a detrimental – albeit temporary – impact on bond returns in the near future. They decide to place a deposit for three years, receiving interest of 1.5% p.a., comparable to the current yield on three-year bonds. In three years’ time when their deposit matures, they end up with the same return as the bond portfolio (green-coloured cell in the table above). Why bother?
Long-term investors should stick with their bond holdings. At some point they will need them to protect against turmoil in the equity markets. Remember ‘You don’t need bonds until you need them!’.