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Should Interest Rate Forecasting Be a Part of Your Bond Strategy?

By: Investor Solutions

By: Investor Solutions, Inc.

Betting on interest rate changes in your bond portfolio is a waste of time. And yet, investors are fascinated with the idea that forecasting will lead to riches and glory. In fact, the Federal Reserve has no direct control over the interest rates that bonds pay. The bond auction, not the Fed, sets the rates for Treasuries and investment banks set the yield for corporate issues when they are underwritten. Rather than worrying about the direction of interest rates, wouldn’t investors would be better served to evaluate the risk and return dimensions of the bond they are buying, specifically as it pertains to maturity?

Now, let’s agree on one thing before we proceed. The whole purpose of having bonds in your portfolio is to further mitigate the risk of an already diversified mix of stocks. Unless you’re a bond trader, I don’t know of anyone who got rich on bonds. Bonds are what I’d call your “insurance policy” in a balanced portfolio-funds that you can access in a market downturn without having to sacrifice equities that may be under water. The key is to select the right balance between risk and return.

Balancing Risk and Return

The greater the risk associated with an investment, the higher the compensation should be -that’s the conventional wisdom (which I happen to agree with). Of the investable assets available, equity is the riskiest while bonds are perceived to be the less risky assets. But, the truth is bonds carry risks that investors tend to overlook, including: default risk, interest rate risk, and reinvestment risk. The longer the maturity of a bond, the more risk it carries. Remember that yields move inversely to bond prices. So, as interest rates go up, your bond value goes down and when rates go down your bond value increases.

Knowing this relationship exists, shouldn’t we use it to make interest rate plays in our bond portfolio? Absolutely not. I would argue that no matter what direction interest rates are headed, an investor should never own a bond with a maturity of greater than five years. Long maturity bonds pay investors additional yield over holding shorter term bonds, that’s true. But, that yield comes at a much greater risk than you might think.

The best way to determine whether that additional risk is worth it is to evaluate the “return per unit of risk” of the investment as it compares to investment alternatives. This ratio attempts to show the relationship between the investment’s historical return and the risk associated with the generation of that return. A return per unit of risk of 1.00 means that for every percentage point of volatility there has been one percentage point of return. The higher the ratio, the better the risk adjusted performance.

In its effort to combat inflation, the Fed has increased the fed funds rate 16 consecutive times over the past two years. And while I told you that the Fed does not directly impact bond interest rates, when the federal funds rate goes up, bond coupons tend to rise as well in anticipation of higher inflation. So, let’s conduct a little study to compare the results of: one month Tbills, one year Treasuries, 5 year Notes, Long Term Bonds and the S&P 500 over the previous two year period (to capture the impact of the Fed’s decisions) as well as a longer term period from 1965 to 2005

Jan 2003 – Dec 2005
1 MonthT-Bills 1 Year US Treasury 5 Year T notes L/T Gov’t Bonds S&P 500
Annualized Return 1.73 1.54 2.31 6.14 14.39
Total Return 5.27 4.7 7.1 19.58 49.68
Growth of $1 1.05 1.05 1.07 1.2 1.5
Annual Standard Deviation 1.09 0.76 0.93 4.19 12.38
Return Per Unit Of Risk 1.59 2.03 2.48 1.47 1.16

We find that the best risk adjusted bond investment for this period was the 5 Year Treasury notes. Although the long term bonds generated a higher return of 6.14%, the additional risk taken for that yield might make that a less attractive investment. The 5 year notes generated the highest return per unit of risk for the period with 2.48%.

Now let’s see if the same holds true for our broader time period:

Jan 1965 – Dec 2005
1 MonthT-Bills 1 Year US Treasury 5 Year T notes L/T Gov’t Bonds S&P 500
Annualized Return 5.89 6.85 7.52 7.71 10.34
Total Return 945.13 1413 1857 2003 5549
Growth of $1 10.45 15.13 19.57 21.03 56.49
Annual Standard Deviation 2.78 3.33 6.61 11.48 16.73
Return Per Unit Of Risk 2.12 2.06 1.14 0.67 0.62

Source: Dimensional Fund Advisors

This time period captures several years of inflation, increasing rates and decreasing rates. Here we find that the annualized returns for the 5 year and long term bonds are not that far off, while the level of risk (standard deviation) is substantially higher for the long bonds. In fact, the level of risk for the long bonds is only 5% lower that the risk of the S&P 500! It’s clear to see that the highest returns per unit of risk were delivered by the Tbills, 1 year Treasury and 5 Year Notes.

We can conclude from this data that it really does not pay to extend bond maturities beyond five years – EVER. And if we hold this to be true, then why bother with interest rate forecasting as part of your bond strategy. The Fed has a deeply important role in our global economy, there’s no doubt about that. But it should have no role in determining your most appropriate bond portfolio.