Bracing for Bondageddon

by Kathy A. Jones, Vice Pres­i­dent, Fixed Income Strate­gist, Schwab Cen­ter for Finan­cial Research

Key points:

• Dire warn­ings about an immi­nent spike in bond yields have been mak­ing the news lately, but we believe some of them are overly dramatic.
• Nev­er­the­less, inter­est rates clearly have more room to rise than fall, and as the econ­omy recov­ers, rates are likely to move higher.
• In our view, investors should man­age their bond port­fo­lios to mit­i­gate the risk of ris­ing rates, rather than aban­don­ing the asset class altogether.
• You can try to lower interest-rate risk by reduc­ing the aver­age matu­rity of bond hold­ings, using lad­dered port­fo­lios and focus­ing on higher-coupon bonds.

"Bondaged­don" now?
Dire warn­ings about the com­ing col­lapse of the US bond mar­ket have grown in fre­quency and vol­ume over the past two years. Some of these warn­ings have come from very promi­nent voices: War­ren Buf­fett was quoted say­ing that bonds are "dan­ger­ous" and "should come with a warn­ing label," while Pro­fes­sor Bur­ton Malkiel of Prince­ton sug­gested in aWall Street Jour­nal edi­to­r­ial that bonds are no longer appro­pri­ate for "pru­dent" investors.
We believe warn­ings like these are dan­ger­ous and impru­dent because they may lead investors to aban­don diver­si­fied port­fo­lios and unwit­tingly take more risk. Let's put the sit­u­a­tion into per­spec­tive: Bond yields have been falling for more than 30 years. The 1.8% low in 10-year US Trea­sury yields reached at the end of Jan­u­ary may be the low­est level we see for a while. How­ever, the "spike" in rates from those lows has been pretty modest.
Ten-Year US Trea­sury Yields Trend Steadily Downward

Source: Bloomberg, as of March 29, 2012.
In our view, cur­rent eco­nomic con­di­tions don't point to a risk of a sig­nif­i­cant increase in rates in the near term. Although the US econ­omy has shown signs of stronger growth, Europe has tipped into reces­sion and lead­ing indi­ca­tors for some major emerging-market economies such as China and Brazil are slow­ing. As a result, cen­tral banks around the globe have been low­er­ing inter­est rates. Infla­tion pres­sures have actu­ally eased since late last year despite the recent rise in energy prices. Finally, we see longer-term demo­graph­ics point­ing to ris­ing demand for fixed income as the pop­u­la­tion ages.  (more)