Bonds, which once had the reputation of being boring but stable are now seen by many investors to be unusually risky. Recent surges in interest rates and news about the Federal Reserve tapering its bond purchases have re-ignited concerns over a "bond bubble" and investors wonder if a bear market in bonds in looming.

While it's a mathematical certainty that bond prices will fall if rates continue to rise, it's important to keep everything in perspective. A recent paper published by Vanguard examines the historical evidence and breaks down the risks investors face today. The most interesting points are summarized below, but anyone concerned about the fixed income portion of their portfolio should read the 12-page paper, which can be accessed here.

Math drives bond returns

A bond's sensitivity to interest rates is measured by its duration (similar to maturity, but factors in all cash flows). The basic rule of thumb is that for every percentage point rise in interest rates, a bond's price will fall by its duration. As of May 31, 2013, the yield of the Barclays US Aggregate Bond Index was 2.1, with a weighted-average duration of 5.5 years. Therefore a 1% increase in interest rates would result in a capital loss of 5.5%. However, it's important to note, this loss would be partially offset by the now higher yield of 3.1%, thus breaking even in less than two years.

 But what if the rise in rates is more dramatic - instead of 1%, it's 3%. Based on the index's duration of 5.5 years this would result in a 16.5% capital loss, offset by the now higher yield of 5.1% for all years going forward. In this case, it would take about three years to break-even. This scenario may lead some to believe they should hold onto cash until rates rise to avoid the large capital loss and then invest in bonds when they're paying a higher yield. If you knew when rates were going to rise this would work wonderfully. Unfortunately, rising rates are very difficult to predict, much like trying to time the stock market.

 We only have to look three years back to see an example of this. In 2010 there were similar fears over rising rates and many investors either significantly shortened the duration of their bonds or moved to cash. Hindsight reveals that interest rates did not move up as many expected. In fact, rates are actually lower now than they were at the beginning of 2010. This provides an important reminder that just because rates are low doesn't mean they can't go lower or that they must go higher.

Although not discussed in the paper, the Barclays US Aggregate Bond Index earned a total return of 16.4% from January 2010 to August 2013. Ironically this would almost be enough to offset the 16.5% capital loss caused by a hypothetical 3% increase in interest rates. If rates rise in the near future investors who have been on the sidelines with cash may be no better off than those who maintained exposure to the broad US bond market. But what if rates don't rise that much or don't rise in the near future? Waiting on rates to rise can have a significant opportunity cost even if you're eventually right about the direction of future rates.

Putting a "bond bear market" in context

Unlike a bear market in stocks, where the common definition is a decline of at least 20%, a bear market in bonds is simply any period with negative returns. According to Vanguard, the worst 12-month period for the US bond market saw a decline of 13.9% in the 70s, contrasted with the worst 12-month period for US stocks which saw a decline of 67.6% during the great depression. Remember also that a bear market in bonds implies higher yields going forward which will help offset the losses. Simply put there is a significant difference in magnitude between a bear market in bonds and one in stocks.

Your portfolio matters most

It's important to remember why bonds are part of a diversified portfolio in the first place. The primary source of both risk and return in your portfolio is equities. The role of bonds is to temper that risk and narrow the dispersion of potential returns in your overall portfolio. Even if the outlook for bonds looks gloomy, they still are an effective tool for balancing your equities and should remain part of your diversified portfolio.

Posted: September 2013