One comment you often hear these days is how lucky bond market investors have been. Interest rates have been falling for decades, and this has led to a huge bull market for bonds. This is the conventional wisdom that everyone has embraced: falling interest rates are good for investors, and rising rates are bad.
The reasoning is straightforward bond math. If interest rates fall then yes, the price of your bond will go up. And vice versa: if interest rates rise then bond prices will fall. Many observers apply the same math to the so-called great bond bull market–the 30-year decline in bond yields beginning in 1981. The assumption is that bond investors have been making out like bandits for decades. And now with interest rates on the way back up, it stands to reason that the bounty has dried up. No more good returns for you bond investors. From here on out it will just be declining prices, doom and gloom.
Here’s the problem with this story: there never was a bond bull market. Those three decades were largely a bad period for bond investors.
Bonds ≠ Stocks
How is this possible? Most investors think of market rallies in equity terms. Say that you had invested $1,000 in the stock market on 9/30/1981 – roughly the date we saw the highest ever long-term bond yields. The S&P 500 Index was at 116. Thirty years later, with the S&P at 1,131, you would have had an annualized return of 10.80% if you had reinvested dividends–a pretty solid return. You bought equities, prices went up and you got to participate in the market rally. All very straightforward.
Now, imagine that you put $1,000 into a brand new 30-year Treasury bond on that same day, 9/30/1981. Since this is a bond you would expect to realize something close to the bond yield if you held it to maturity, around 15%. Yields then fell for the next 30 years to around 3%. Wow, a 15% starting yield, plus falling interest rates. Your return must be really good! In fact, your return from holding your bond over that period and reinvesting the coupons as they came in would have been… about 10%, or roughly 5% lower than your initial expectation. Yes, you still got a good return, but it was less than you expected–despite the supposed bond market rally.
What happened? You bought a bond near all-time high yields, and held it through what has been called the greatest bond bull market of the past century. How could you get 5% less than you expected? The answer is simple: falling yields are not good for long-term bond investors.
To understand this, we need to peek into how a bond’s yield is calculated. When you see that 15% yield on the 30-year Treasury there are a couple of assumptions being made. One of them is that every six months when you receive a coupon payment, you are reinvesting it back into the market at that same initial 15% rate. This is a fine assumption when you start, as you don’t really know which way interest rates are going to go. However, if yields are declining, each coupon payment is being re-invested at lower and lower yields, leading to a lower return than you expected over the life of your investment. This is compounding interest in action. A lower interest rate, compounded over a 30-year period, can lead to a significantly different outcome.
Take a look at the graph below. The bar on the left shows you the cash flows you would have received from buying that 15% yield bond in 1981 and reinvesting your coupon payments back into the market as you received them. From that $1,000 you put in in 1981 you would have received back over $18,000 30 years later. The bar on the right shows you what you would have gotten back if you had purchased that same 15% bond in 1981, and yields had remained at 15% for 30 years. You would have gotten back over $75,000 dollars! Investing at higher yields has a real impact on your cash flows over 30 years.
Know your short from your long
Where does this fiction about falling yields being good for bond investors come from? It comes from shorter-term bond investors who are seeing the value of their bonds rise as rates decline, and who aren’t factoring in the impact of compounding interest over time. A short-term investor could sell their bond when it rose in price, and realize a benefit from falling interest rates. A longer-term investor who holds her bonds to maturity never realizes any gains on that original bond. The $1,000 you put into that original bond returned $1,000 30 years later. Most of the return comes from reinvesting that bond’s coupons along the way. The only way to benefit from falling yields is to sell a bond that has gone up in price. My example above used a single bond, but you would have gotten a similar result if you had bought a bond ladder or even a bond fund. Any strategy that holds bonds to close to their maturity is penalized by falling interest rates over long periods of time as coupon payments are reinvested at lower and lower yields.
Critics of this logic might say “of course you have to sell things when they go up in price.” After all, in my equity example, the investor only gets that 10%+ return if they sell their S&P 500 investment at the end. This is true, but it misses a key distinction between bonds and stocks. If you buy a stock and hold it, you will realize the return of that stock, either up or down. If you buy at $100 it could rise to $150, or fall to $50. You hope it will go up in price, but you have no surety around what it will be worth in the future.
However, if you buy a bond, you expect regular income payments and then your money back at maturity. There is no expectation that you will get more than what you put in when the bond matures. A bond you buy at $100 may rise in price to $150, but if you keep holding that bond, it will fall back to $100 when it matures. Any gains or losses that a bond experiences disappear as it approaches maturity and the price pulls back to its initial par.
In other words, changes in bond prices decay, equity price changes do not. This is one of the most overlooked concepts in investing, and what really separates fixed income from equities.
Short- to intermediate-term investors, and those who opportunistically harvest gains, would have had a different experience in the 30-year period outlined above. If I had sold my 15% 30-year bond five years after purchasing it, I could have gotten over $160 for a bond I bought at $100. Even if I were just monitoring the current market value of my investment I would have seen a significant price increase in the early years, driven by falling yields. And if I were invested in a mutual fund, ETF or other managed fund I would have seen the value of my investment rise as well. Falling yields do lead to higher bond prices. But all those bonds that rise in price will mature at par.
In the end, bond price gains are transient for the long-term investor. What really matters is the level of yields at which you can invest in the future, as we’ll see in my next post.