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Why Buy Bonds If Interest Rates Will Rise?

by Hildy Richelson and Stan Richelson

Why Buy Bonds If Interest Rates Will Rise? Splash image

Many individual investors wish to buy bonds to achieve a secure cash flow and to reduce their risks in the stock market.

However, with interest rates at a low level, some investors are concerned that after they purchase bonds, interest rates will rise and their bonds will decline in value. We examine the validity of this concern, certain alternatives to bonds and our proposed solution to low interest rates.

In this article


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About the author

Hildy Richelson is president of Scarsdale Investment Group, a registered investment adviser based in Blue Bell, Pennsylvania, that specializes in fixed-income investments. Hildy and Stan Richelson are co-authors of several books on bonds, including “Bonds: The Unbeaten Path to Secure Investment Growth,” Second Edition (Bloomberg Press, 2011).
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Stan Richelson is a representative of Scarsdale Investment Group, a registered investment adviser based in Blue Bell, Pennsylvania, that specializes in fixed-income investments. Stan and Hildy Richelson are co-authors of several books on bonds, including “Bonds: The Unbeaten Path to Secure Investment Growth,” Second Edition (Bloomberg Press, 2011).
Stan Richelson Profile
All Articles by Stan Richelson

You should not have to wait until the end of this article to get to our proposed solution to the low interest rate problem: We propose a bond ladder of individual bonds structured to take into account your financial needs and objectives. The bond ladder will finesse the possibility of rising interest rates. A bond ladder will also enhance your appreciation of the value of cash flow and power of compound interest.

The Problem of “Low” Interest Rates

We are told by the pundits and brokerage firms that rising interest rates are inevitable, like death and taxes. We believe that at some time in the future interest rates may rise, but no one really knows when this might happen. That does not stop the media from making dire predictions about the losses that will be inflicted on bondholders in the form of lower market values. To minimize these losses, the brokerage firms have been recommending investing in what we consider to be short-term bonds (around five years). If you followed this advice for the last five years, the result would have been a greatly reduced cash flow for many years and a loss of compounding the cash flow, as can be seen in Figure 1. And, interest rates have not yet gone up.

The truth is that no one really knows when or if interest rates will rise from current levels. The U.S. is currently beset with many problems. We are still recovering from the great recession, economic output is growing extremely slowly, real business investment is still slow and the reduction in the unemployment rate is inconsequential. Real median family income growth and middle-class jobs have declined. In view of these economic problems and the fact that the Federal Reserve is suppressing interest rates, it is unclear whether interest rates will spike up any time soon.

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If everyone really believed that interest rates were going to rise substantially in the very near future, rates would go up immediately.

There are three possibilities with regard to the movement of interest rates:

  • Interest rates in the future may go up,
  • Interest rates may go down or
  • Interest rates may stay within the current range.

Unfortunately, no one really knows what will happen. We personally come from a place of not knowing—we know we don’t know the direction of interest rates, and we have not found anyone with a consistent track record of predicting the direction of interest rates.

Mark-to-Market Accounting

We believe that the mark-to-market accounting concept is clouding individual investors’ understanding of the true nature of bond investing. The concept of mark-to-market means that every day, week, month or year (or multiple times a day), the current price of a bond is compared to the price at which you bought the bond. If interest rates go up, the market value of your bonds goes down and you are supposed to feel distressed about your bond investment. If interest rates go down, the market value of your bond goes up and you are supposed to feel happy and contemplate selling and taking your gain.

Although mark-to-market accounting is used by all brokerage firms, we believe that the concept is inappropriate for individual investors who are buying and holding individual bonds until their due date rather than trading their bonds. Why should gains and losses be presented when the bond coupons stay the same? Since the bond coupons remain unchanged, whether interest rates go up or down, the cash flow from the bonds stays the same. You receive the same income stream no matter what the price of your bonds is today or tomorrow.

Mark-to-market accounting is appropriate for bond funds since the funds never come due. The bonds in the fund must be sold when they no longer meet the fund’s maturity specifications. Institutions must use mark-to-market accounting, but individual investors are not required to do so. If you use mark-to-market accounting, you will be terrified of rising interest rates. Brokerage firms like mark-to-market accounting because it encourages investors to buy and sell bonds, rather than hold individual bonds to maturity.

The media is hyperventilating over the possibility of long-term interest rates rising. For example, it was reported as news that the Barclays U.S. Aggregate Bond Index (the Agg), which tracks the broader bond market, declined 0.12% in the first quarter of 2013, the first negative quarter since 2006. However, most bonds are not reflected in the index, and most bond funds do not track it. In another example, The Wall Street Journal reported that “The guiding star for many bond investors is starting to flicker.” Flicker, by definition means to shine with a wavering light, a light that soon may go out. However, any rise in interest rates has to date (April 5, 2013) been inconsequential.

Alternatives to Individual Bonds

Let’s look at the alternatives to buying a portfolio of high-quality individual bonds.

One option is to stay in cash or cash equivalents (short-term Treasuries and insured bank products). Many investors would like to invest in these products to deal with the current uncertainties. However, everyone knows that interest rates are currently so low that the only way these products make sense for anything beyond very short-term (e.g., emergency) savings is if interest rates were to spike up quickly in the near future.

With interest rates low as a result of the repression of rates by Federal Reserve Chairman Ben Bernanke, investors have been encouraged to invest in riskier asset classes to try to improve their returns, even if they can’t realistically afford the consequences of bad outcomes. Thus, investors have gone heavily into stocks, commodities, collectibles, junk bonds and other risky investments. Many of these investments are inappropriate for investors who have limited resources and who are nearing retirement or are in retirement because the downside risks are too great. Even dividend-paying stocks come with an uncertain outcome since, unlike bonds, they never mature and are subject to the stock market’s volatility.

Floating rate notes have recently gained in popularity because it appears that they might enable you to hedge your bets. For example, one bank offered a step-up certificate of deposit (CD) in April 2013 that matures in 2018. For the first three years the interest rate is fixed at 0.85%, the rate you could get currently on a one-year CD. In year four, the interest rate rises to 1.25%, which is the current rate on a four-year CD. In year five it rises to a 2.00% yield, which is currently an above-average return. The problem with this investment is that you are locked in for five years. However, the issuer is locked in for only three years because the CDs are callable every quarter after April 2016. Keep in mind that for the first three years, you are being paid only 0.85%.

So, if rates are too low on traditionally safe investments, the risks are too great on commodities and junk bonds, and stock prices are subject to the market’s volatility, what strategy should investors follow?

The Benefits of a Bond Ladder

Individual investors are not institutions. We don’t live forever. We should focus on our finite lifetime needs and goals, taking into account the risks of investments.

We recommend that you consider the benefits of a custom bond ladder. Briefly, a bond ladder of individual bonds is a strategy to have one or more bonds come due in multiple years. Thus, if you have $100,000 to invest, you might have a $10,000 bond come due in each of 10 different years beginning in 2014 and ending in 2033. This is the simplest form of a bond ladder. Alternatively, you might start your bond ladder in 2023 or later years and end in 2036 and have unequal amounts of bonds in each year.

In the strategy of the bond ladder, we find the solution to the problem of losses being generated from rising interest rates when using mark-to-market accounting. Whether interest rates are rising or falling, your bond ladder of high-quality bonds will produce a consistent cash flow that you can rely on.

If your bond ladder is in place before interest rates go up, you have the upside case when rates rise. This is because as interest rates go up, you will be able to increase your cash flow by reinvesting your bond proceeds (from bonds coming due and bonds being called) and your excess interest income in higher-yielding bonds. For example, if you are getting a 4% return and interest rates rise enough over time to give you a 6% return, your cash flow over time will increase by 50%. Thus, if your bond ladder is in place, rising interest rates will not be a concern but will be your upside case.

Guidelines for Laddering

Consider the following guidelines in the design of your buy-and-hold bond ladder.

First, consider whether there are certain years in which you know you will need cash. For example, if your child or grandchild will begin college in six years, you may want to have one or more bonds come due in years six, seven, eight and nine. If you plan to buy a residence in five years, buy bonds that will come due at that time. Always keep enough of a cash cushion so that you can be a buy-and-hold investor.

Second, once you have taken care of your known needs for cash, consider the shape of the yield curve. The yield curve is a chart that plots the interest rates being paid by bonds of the same credit quality but different maturities. In the chart, the interest rate is found on the vertical axis and the maturity on the horizontal axis. A current yield curve for AA-rated tax-free municipal bonds is found in Figure 2.

Third, creating a ladder of short-term bonds will protect you against interest rates rising in the near future. However, whatever kind of bonds you purchase for your short ladder, they will provide only a small return in today’s bond market. Since the yield curve is currently very steep, you will receive a lot more return for investing in longer-term bonds than very short-term bonds.

Fourth, keep in mind that every year that passes, the entire bond ladder gets one year shorter. In addition, longer-term bonds provide a greater return and may enable you to reinvest excess cash at a higher rate of return.

Fifth, since we don’t know whether interest rates are going up or down, or the timing of such moves, our advice is to get your bond ladder in place as soon as possible. Waiting for interest rates to rise before you establish your bond ladder may result in the loss of a great deal of cash flow while you are waiting, if your timing is not precise.

Our Current Strategy

In the current environment (April 2013), the yield curve is very steep, meaning that long-term bonds yield a great deal more than short-term bonds. In this environment, we suggest the following strategy.

Purchase bonds that are free of federal income tax for your taxable accounts.

All bonds should generally be rated at least AA by Moody’s and Standard & Poor’s or by at least one of these rating agencies. The bonds should fall into one of the following categories:

  • Certain state general obligation bonds generally rated at least AA,
  • Certain county and city bonds generally rated at least AA,
  • Certain essential services bonds generally rated at least AA or
  • Bonds of certain universities generally rated at least AA.

The bonds should be purchased to form a customized bond ladder designed for your financial needs. If you have no special needs, we recommend buying bonds with due dates ranging from 15 to 23 years to maturity with attention paid to first call dates.

Your customized bond ladder of high-quality bonds will result in the following outcomes:

  • Preservation of your wealth,
  • Creation of a reliable and predictable cash flow,
  • Reduction of your federal income taxes and
  • Preservation of wealth for your heirs.

Buy Individual Bonds Not Funds

When we speak of bonds, we do not include bond funds. There are many differences between individual bonds and bond funds. The following are a few highlights.

Bond funds are not bonds; they are quasi-equities that don’t come due. Individual bonds have a due date. A fund has to sell bonds that no longer meet its objectives and purchase new bonds at current market rates. If interest rates are falling, the bond fund must purchase new bonds at those lower rates. If interest rates are rising and there are many redemptions, the fund must sell bonds into the rising interest rate market in order to meet their redemptions. An alternative is to keep substantial sums in cash earning nothing, which also lowers the fund’s returns.

If you purchase bond funds, you are making a bet that interest rates will either stay the same or decline. If interest rates were to rise significantly, you are making a bet that you can time the market—turn and trade out before you lose a great deal of money. By comparison, while individual bonds may have the same market volatility as bond funds, as an individual bond approaches maturity its price will move closer to its face value and its volatility will decrease.

Although you can trade out of a bond fund more easily than individual bonds, since you can hold individual bonds until their maturity and receive a fixed amount (the bond’s par value), you will not have to trade them to get your investment back. Trading in and out is expensive and is for professional traders. Individual investors generally find it quite difficult to make two right decisions: when to buy and when to sell. If you sell at a profit, Uncle Sam is the first one to congratulate you and take his share.

It is not possible to determine the cash flow that you will receive on a bond fund because of a number of variables: trading results, future interest rates, expense ratios, trading costs and changes in holdings. Reporting of fund returns varies from fund to fund.

  Taxable
  Equivalent
2013 Tax Bracket Return (%)
33% 5.97
35% 6.15
39.6% 6.62

Many bond funds invest in lower-grade (riskier) bonds to stay competitive with other bond funds and to cover their fees and expenses. Some funds are leveraged (use borrowed money) and thus are more volatile than individual bonds. They may be benchmarked to show performance, but the benchmark may itself keep changing. Some funds also use derivatives in the hope of increasing their returns. This will also magnify their losses.

Conclusion

Here are our recommendations for how you should proceed in today’s “low” interest rate environment:

  1. Define your objectives and financial needs. We always can use more, but if you look at the bottom line, you can provide for what you absolutely need and then work for the rest.
  2. Determine your asset allocation between how much of your portfolio you wish to keep safe in a custom bond ladder and how much you will use to speculate.
  3. Don’t worry about timing interest rates in the market—you probably can’t anyway.
  4. Set up your custom bond ladder now to generate a consistent cash flow.
  5. Invest your taxable account in high-quality tax-free municipal bonds.
  6. Sit back and relax knowing that if interest rates go up after you establish your bond ladder, that is your upside investment case.

A final and important note for investors in a high tax bracket: The yield to maturity on a long-term high-quality municipal bond in April 2013 is now 4.00%. The tax-free equivalent return for a 4.00% yield to maturity for taxpayers in various tax brackets is displayed in Table 1. These may be attractive returns for high-quality investments if predictions of the so-called “new normal” turn out to be accurate.

Hildy Richelson is president of Scarsdale Investment Group, a registered investment adviser based in Blue Bell, Pennsylvania, that specializes in fixed-income investments. Hildy and Stan Richelson are co-authors of several books on bonds, including “Bonds: The Unbeaten Path to Secure Investment Growth,” Second Edition (Bloomberg Press, 2011).
Stan Richelson is a representative of Scarsdale Investment Group, a registered investment adviser based in Blue Bell, Pennsylvania, that specializes in fixed-income investments. Stan and Hildy Richelson are co-authors of several books on bonds, including “Bonds: The Unbeaten Path to Secure Investment Growth,” Second Edition (Bloomberg Press, 2011).


Discussion

Walt B from FL posted about 1 year ago:

This article advises using individual bonds vs bond funds. You can find a publication ("A topic of interest: Bonds or Bond Funds") on the Vanguard web site that recommends the opposite. Vanguard focuses on increased liquidity,lower transaction costs (bid-ask, wholesale vs retail) and the diversification advantages of funds. They also recognize the control advantages from individual bonds.

It sure would be nice to see some real numerical analysis. Individual bonds are an asset class as are bond funds. When calculating the efficient frontier, you can use either. What's the difference in expected return for a simple asset allocation, viz., 60:40 stock index: bond using the two different bond asset classes?


Howard... from Oregon. posted about 1 year ago:

I hold Oregon mutual's, in an state fund that has a fairly long duration, but covers all taxes
(Oregon tops at 9.3%) The price has increased, as well as the return. My other major holding is
in the Vanguard Hi Yield bond fund. The asset value of this fund has increased nicely, and the return, in an IRA account, defers the taxation.

OK, I am sitting on a time bomb when rates move up. I still recall the hit I took in the 90's sitting on bond funds! However as long as Uncle Ben continues the current policy game I feel ok. When I see a change afoot, I will go to cash. This is easy to do with these funds.


Lee from MD posted about 1 year ago:

Planning on holding a ladder of longer term bonds to maturity in our old age (say 85 plus) may not work so well providing income while we are alive. I would appreciate an analysis proving feasibility of this situation or a caution against using such a ladder should be added. Over which age groups does the article's recommendations apply?


David from Vermont posted about 1 year ago:

As Walt B says, it would be nice to see some numerical analysis - what does happen to a bond fund, in absolute terms, with rising interest rates and redeposited interest dividends? How does that compare to a bond ladder? And does a bond fund merely make immediate the lost interest that is hidden in a ladder? Which in dollar terms returns the more over years of up or down markets? Thank you.


skibutch. from California posted about 1 year ago:

I thought this was a very informative article. When you buy a bond, your principal is protected from market fluctuation. I find this comforting in the current environment.

However, it is important to remember that even with the principal protection, you can loose a lot of valu to inflation.


MP from NY posted about 1 year ago:

If for all those years the High yield bond funds were doing good, if we were to take a hit when interest rates go up, I believe we are still better off then keeping it in cash or low yielding bonds(in tax deferred account). If we are long term investors, I don't see a problem with a quality High Yield Bond Fund.


Jay from California posted about 1 year ago:

Walt - Where is that Vanguard article on their site? I couldn't find it.


Jay from California posted about 1 year ago:

What I don't understand about this article is that it is suggesting laddering your bonds with due dates from 15 to 23 years, while elsewhere in the article it talks about time frames of five to ten years. I don't want to lock up my money for a minimum of 15 years when interest rates may be going up in the next few years - I will want to cash out then and invest in higher-yield bonds. Also I am within about 12 years of retirement age. It would seem to make sense to invest in bonds with a maturity of from 2 to maybe 5 years, no?


Samuel Dollyhigh from SC posted about 1 year ago:

I agree with Jay. I was surprised to read 15 - 23 years as a recommendation. As the article states - shortening up on duration would protect against rising rates. I don't know why you wouldn't want to do this in the current environment. To me the bond ladder should start somewhere between 2 and 5 years and then extend from there to longer duration bonds.


hildy from Pennsylvania posted about 1 year ago:

We recommend bonds in the 15 to 23 year range because that is where the yield is. That is the same reason Willy Sutton gave when he asked why he robbed banks. "That is where the money is." he replied. If the Fed starts to raise short-term interest rates, then our recommendation would probably change. However, if you want some yield 2 to 5 year maturities just doesn't do it! 5-year Treasuries are currently paying 0.83% taxable, while double-A rated munis are paying 0.99%. 20 year munis with the same rating are paying better than 3% currently, federal, state and maybe local tax-free.


SJ from NY posted about 1 year ago:

Buying individual bonds seems to be the way to go, but there is enough literature out there that says that it is not for the retail investor. Unlike stocks, the bond market is not very liquid and that one could get squashed by the bid-ask spread. Few articles seem to address this issue. Of course, if one directly buys from the Treasury, one avoids this problem, but for corporates and municipals one has deal with the spread. I have also noticed the lack of articles, even in the AAII, about how to intelligently go about buying bonds.


Hildy from PA posted about 1 year ago:

The problem with high yield bond funds is that there has been such demand for yield that the spreads between the high yield bonds and investment grade bonds have narrowed. You can expect the spreads to widen as interest rates on higher quality bonds improve and more pressure is put on the strained resources of the issuers of those high yield bonds.

For a bond investor, rising interest rates are the upside case if you can reinvest the interest payments into higher yielding bonds. It is like income averaging up for stock investors.

SJ Please read about buying individual bonds in our book: BONDS: The Unbeaten Path to Secure Investment Growth, 2011 - second edition.

Thank you for your remarks, David.

Lee, losses are not hidden in the ladder because the bonds ultimately come due at face value. The bond funds never come due. This is why bond funds use the concept of modified duration, which is the amount of time it takes to get interest and principal back. Each year implies a 1% change in the price when or if interest rates go up or down 100 basis points.

Thank you for your comments.


Ian from Pa posted about 1 year ago:

This was a very interesting article. I also think that an alternative ladder could be built with some of the new defined maturity ETFs currently offered by iShares and Guggenheim. I wonder if anyone else has any thoughts or experience with these.


Charles Rotblut from IL posted about 1 year ago:

Hi Ian,

I'm starting to look into defined maturity funds for a future AAII Journal article.

-Charles Rotblut


Bernie Tarango from CA posted about 1 year ago:

This is a very one sided article.... there is no mention of transaction costs ( especially with the low amount 100K of investment). Also, there is also the risk of loss ( even with high quality) that are not factored. Very disappointed in the analysis and presentation of facts.....


Harry from PA posted about 1 year ago:

A couple of quick points.
Willie Sutton never said that, but did use it for the title of a book.
If you can't find an article at a web site, for ex. Vanguard, use Google. Google's search is better at finding articles anywhere on the web than VG's search is for just its own web site.
For me the argument that a bond doesn't lose value but a bond mutual fund does is equivalent to sticking your head in the sand. If a I bought a bond yesterday and put it in my safe deposit box, it's easy to ignore the fact that I just "lost" money today because rates went up.
But if you don't sell then you don't lose anything either way.


James Pier from OH posted about 1 year ago:

There's a reason Warren Buffett's asset allocation advice is a whole lot different than 100% bonds.

1. The Richelsons' advice is clearly biased, and AAII owes it to its membership to publish that caveat. If one's entire advisory business is built on advising investors to invest in bonds, not to mention selling books with that advice, then one is not about to come out and say that bonds are the wrong place to be, or even relatively high risk in the current environment.

2. The long-term average returns for stocks and bonds and other asset classes are interesting, but certainly not dispositive in making decisions. One must consider each alternative at the then available market price. Buying high, even if one doesn't intend to sell low, can only lead to lower-than-average returns over time. As the authors rightly point out, one difference between bonds and stocks is that bond prices tell you right up front what the held-to-maturity return will be. Bonds are currently so close to their ALL-TIME highs as to make their purchase at least very questionable. Find a long-term chart of bond prices and see for yourself--buying now looks crazy. In hindsight, buying stocks in late 1999 was a bad idea, but it sure was easy to feel smart doing it then.

It makes no difference that "nobody knows when rates will go up." The fact is that yields are very low--inadequate to build wealth and dangerous vis a vis maintaining wealth while drawing income. Unless one is already quite wealthy, 100% bonds is as sure a loser as one can find among the various asset classes. It is not a question of whether bond prices will fall, only when, how much, and how fast.

3. What difference does it really make if I ladder my portfolio? Suppose I hold 10 bond positions of laddered maturity, and one of them comes due during a higher-rate environment. I can reinvest 10% of my portfolio at a higher rate. Oh good. The other 90% I hold at a loss, whether I want to sell them or not, and I continue to suffer with their dismal yields. Building a bond ladder of 15-23 year duration today means locking in low returns on most of your portfolio for an awfully long time.


Hildy Richelson from PA posted about 1 year ago:

Dear Mr. Pier,

We cannot foresee the future and therefore cannot advise our clients to try one investing alternative rather than another based on prospective outcomes. What we suggest is a low cost strategy that has fairly predictable outcomes. We do not say that it is perfect, nor do we say that this is the solution for every investor.

For high net worth individuals, and investors who follow the credo "Slow and steady wins the race," investing in high quality individual bonds creates a predictable stream of income. As interest rates rise, they can reinvest the income into higher yielding bonds.

I don't know about you, but I prefer to reinvest at higher interest rates. Waiting until they rise has its own costs, as many investors found. They created five year, short-term bond ladders yielding nothing because they knew that interest rates would soon rise. They lost the opportunity to have the interest payments compound - the basis of growth in bond investing.

Stock market investors required extraordinary staying power to wait more than ten years until stock prices picked up. Long term stock investors saw volatility for many years, but it was not until 2012 that the stock market finally rose above the March of 2000 high.

There is no perfect advice for anyone. Each of us has to weigh the information and then chose the best path. Investing in high quality bonds provides greater predictability, and some investors may chose that despite the downsides.


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