Are Bonds Safe When Interest Rates are Rising?

History shows that fears of bond losses when interest rates rise are largely overblown.

illustrative chart with arrow hitting target

By their nature, most stocks are riskier investments than most bonds because debt holders get paid before stockholders if a company goes bankrupt. But are bonds still safer when interest rates might be rising?

Because U.S. interest rates are still near their historic lows, many investors ask this very question. To provide as clear an answer as possible, we reviewed data from the past 30 years, spanning five periods of interest rate hikes. We evaluated how these upward changes in interest rates affected various types of bonds.

We’ll start with the short answer. In the last 30 years, the data shows that fears of bond losses during rising interest rates are largely overblown. See below for why we say that.

Regardless of the type of bond or how the rates changed, bonds have been consistently less risky than stocks. That’s one of the reasons why bonds play a vital role in every portfolio strategy Betterment offers.

Still—the story of bonds and interest rates is a fascinating one. Let’s dig into the data, and you can judge for yourself whether you should be concerned with a potential future of higher interest rates.

We analyzed four types of bonds over 30 years of performance data.

When deciding which bond data could most accurately depict the relationship between interest rates and bonds, we made three important decisions.

  1. We chose actual bond funds instead of indices. After all, customers cannot invest directly in an index, so it’s more accurate to review actual investable products.
  2. We chose funds that had a long enough track record to span multiple periods of rising rates. That way, we had plenty of data to analyze.
  3. We also chose funds that invested in specific sectors of the bond market, so that we could compare how interest rate effects may have varied by sector.

These three criteria led us to using four bond funds from Vanguard as our data sample. Each of these funds has been around since at least 1987, giving us approximately 30 years of performance data. We gathered the data from Yahoo Finance and Vanguard. Here are the four funds.

  • Vanguard Short-Term Investment-Grade Fund Investor Shares (VFSTX)
  • Vanguard Intermediate-Term Tax-Exempt Fund Investor Shares (VWITX)
  • Vanguard Total Bond Market Index Fund Investor Shares (VBMFX)
  • Vanguard Long-Term Investment-Grade Fund Investor Shares (VWESX)

Now which interest rate data did we use? Following convention, we used the historical Federal Funds Rate for the same 30-year period, as published by the Federal Reserve Bank of St. Louis. From this data, we can see there were 5 distinct periods of rising interest rates in the United States during this time period (1987 - 1988, 1994 - 1995, 1999 - 2000, 2004 - 2006, 2015 - 2017). Throughout our analysis, we’ll focus on these 5 periods (see graph).

Effective Federal Funds Rate (Jan. 1987 - Aug. 2017)

Rising Rate Periods

The above graph shows rise and fall of the U.S. Federal Funds Rate. You can see that since 2009, the rate has been historically low, which is why many investors feel nervous about the potential for rates to rise.

How have bond funds performed during rising interest rates?

Using calendar-year annual performance data, we wanted to answer 3 questions for each of the five periods of rising interest rates:

  1. Did rising interest rates cause losses for bonds?
  2. If so, how extreme were the losses?
  3. How quickly did bonds recover?

1. Did rising interest rates cause losses for bonds?

The first, and biggest question to answer is whether or not bond funds experienced losses during rising interest rate environments.

The table below shows the worst-performing year for each bond fund during each of the 5 rate hikes, with all negative returns highlighted in red. For example, during the 2 years of rising rates from 1994 - 1995, the worst year for long-term bonds was a loss of 5.3%. But during the 3 years from 2004 - 2006, the worst year for long-term bonds was still a positive 2.9%.

Fund returns during the worst single calendar year in given period

Time Period Short-term bonds (VFSTX) Intermediate municipal bonds (VWITX) Total bond market (VBMFX) Long-term bond (VWESX)
1987-1988 4.5% 1.6% 1.5% 0.2%
1994-1995 -0.1% -2.1% -2.7% -5.3%
1999-2000 3.3% -0.5% -0.8% -6.2%
2004-2006 2.1% 2.2% 2.4% 2.9%
2015-2017 - YTD 1.0% 0.1% 0.3% -2.2%

Short-term bonds, the least volatile of the group, only experienced a loss during one of the five rate hikes. Even long-term bonds, the most volatile, reported losses in only 3 of the 5 rate hikes.

What we see from the data is that rising interest rates affected each bond sector differently, but only caused negative overall performance less than half of the time. In other words, the notion that interest rate increases always result in losses for bond funds is far from the truth.

2. How extreme were the losses?

We’ve now established that rising interest rates do not always mean negative returns for bonds. But when bonds do experience losses, how significant are they? And how do these losses in the bond market compare to a bad year in the stock market?

The table below shows the average loss for each bond fund and the largest loss during the last five rate hikes.

Short-term bonds (VFSTX) Intermediate municipal bonds (VWITX) Total bond market (VBMFX) Long-term bond (VWESX) Large US Stocks (VFINX)
Average Calendar-Year Loss during Period of Rising Rates -0.1% -1.3% -1.7% -4.6% -16.7%
Largest Calendar-Year Loss during Period of Rising Rates -0.1% -2.1% -2.7% -6.2% -37.0%

The largest annual loss was in the long-term bond sector, and was only 6.2%. And aside from long-term bonds, which advisors generally assess to be the most risky bond class regardless of rates, the biggest loss in our analysis was -2.7% for the total bond market.

For context, let’s compare these bond losses to US large company stocks, as exemplified by the Vanguard 500 Index Fund (VFINX). In the same 30-year period, US large stocks have had 5 years of negative returns, with an average loss of -16.7%. That’s about 3.5x larger than the average loss for long-term bonds. The biggest annual loss for US large company stocks was 37.0%, or about 6x larger than the largest loss for bonds!

The key takeaway here is that even a bad year for bonds is negligible when compared to a bad year for stocks. Bonds historically have had fewer losses, and the losses they do experience have been smaller than stock losses. This is why it is prudent to reduce your risk by replacing some of your stocks with bonds as your goal gets closer. And that advice still stands, even when interest rates are rising.

3. How quickly did bonds recover?

So rising interest rates haven’t always spelled negative returns for bonds, and even when they do, the losses have been small, especially relative to stock market losses. However, losses, no matter how small, are still undesirable for any investor.

So the last question we wanted to address was: After bonds experience a loss, how long does it take for them to recover? What we found was that losses for bonds have been consistently short-lived. In fact, there was not a single occurrence of back-to-back losses for bonds during the past 30 years.

That is what each of the graphs below demonstrate. Assume you invested $100 on January 1st of the worst year during each interest rate cycle. That is your “Initial Deposit.” After one year, you may have lost money, but in the year immediately following, you made your money back, and then some.

Loss to positive results bonds

For the graphs above, “Initial Deposit” is a hypothetical deposit of $100 just before the start are of the worst performing year. We describe these graphs in terms of dollars, to more easily communicate how the value falls and increases over time.

As made clear by the charts, the bonds’ respective worst years in each period of interest rate hikes were all subsequently followed by years with positive annual returns. In each case, the losses of one calendar year led to gains the next calendar year.

Interest Return vs. Price Return

We’ve now established that rising rates do not always mean negative returns for bonds. And when bond losses have occurred, they have been minor, and they’ve typically been short-lived.

Part of the reason for this trend in the historical data is because when rates start to rise, new bonds are more likely to pay you higher coupon payments moving forward. This is because as interest rates rise, investors will demand higher coupon payments from bonds. Why buy a bond that is still only paying 2% when a savings account will now pay you 4%?

This is important because coupon payments account for the vast majority of the overall return investors receive from bond funds.

The chart below shows the average total annual return for each of the 4 bond funds previously mentioned, broken out by price return and income return during the last 15 years from 2002 - 2016 (as far back as the price/income return data was readily available). Again for comparison, the Vanguard 500 Index Fund (VFINX), a fund composed of U.S. large cap stocks, is also included.

Total Returns on Analyzed Bond Funds (2002 - 2016)

Income during rising rates

For each type of bond fund, more than 75% of returns came from interest income, not from the bonds themselves appreciating in value. The large cap stock fund, on the other hand, received less than 33% of its growth from income via dividends.

This data shows that temporary drops in the price of bonds you own is not the main factor that affects your overall returns. In fact, rising rates, often results in higher income from bond coupon payments, which is the largest driver of bond returns.

How Betterment Builds and Selects Bond Baskets

The analysis presented above represents a body of research on bonds that reflects why Betterment continues to include bonds in the Betterment Portfolio strategy even while interest rates are rising. It’s also one reason why we chose BlackRock’s target income portfolio strategy (100% bond portfolios) for income-focused investors who prefer not to invest in stocks.

1. For both portfolio strategies, Betterment recommends that at least some part of your portfolio be invested in bonds—regardless of rising interest rates.

Owning bonds still remains one of the best ways to manage overall risk in your investment portfolio. Choosing to avoid bonds and instead maintain a high balance of stocks in your portfolio may mean taking on more investment risk than is appropriate for your goals or personal tolerance. For more income-focused investors, this holds true as well. With interest rates at historic lows during the past 8 years, many have chased extra yield by investing in assets such as dividend-focused stocks and REITs, both of which have significantly more downside risk than bonds do, even when rates are rising. That’s why the BlackRock Income Strategy invests exclusively in bonds, aiming to balance income and risk.

2. Both portfolio strategies control exposure to long-term bonds.

As shown in our analysis, long-term bonds are more volatile than short & mid-term bonds, particularly when interest rates rise. This is one of the reasons why the Betterment Portfolio controls exposure to long-term bonds. This can be measured by the duration of the bonds held within the Betterment Portfolio. The average bond duration in the Betterment Portfolio varies depending on your risk level, but it generally ranges from 0.39 to 6.94. This is about half the duration of the long-term bond VWESX which is currently 13.76. The duration of the BlackRock Income Portfolio Strategy option is also much lower, ranging from 2.43 to 5.48.

The key takeaway is that rising rates affects different sectors of bonds in different ways. By controlling exposure to long-term bonds, we have historically been able to help minimize the effects of rising rates on your portfolio.

3. For low risk goals, both portfolio strategies increase exposure to short-term bonds to manage risk even more.

For investors who want to minimize risk as much as possible, simply avoiding long-term bonds may not be enough. Whether you have a very short time horizon or wish to invest in a very conservative manner, both the Betterment Portfolio strategy and BlackRock’s Target Income portfolios have lower risk options that can make sense. At low risk levels (less than 40% stocks and below), the Betterment Portfolio begins to phase in Treasury Inflation Protected Bonds and Short-Term Treasuries, for increased risk reduction. The most conservative option in the BlackRock Income Portfolio currently has the majority of its holdings in bonds with bond maturities of less than three years.

Final Thoughts

Data shows the fear rising interest rates is largely overblown.

Television hosts and financial salespeople have worked hard to warn investors of the upcoming “bond armageddon” as interest rates rise. Yet, the historical evidence doesn’t support that claim. Even during rising rate environments, bonds have historically still posted positive total returns.

Rising rates can actually improve the main driver of bond returns, which is the interest income you receive.

Owning bonds remains one of the most effective ways to reduce the risk of your portfolio. We at Betterment use all of this research to back our advice for portfolios that include bonds, helping our customers invest their money in a way that matches their goal horizon and their tolerance for risk.

The figures contained in this article have been obtained from third party sources, and their accuracy and completeness are not guaranteed by Betterment. All performance data quoted represents past performance, and past performance is not indicative of future returns. The conclusions drawn in this article should not be construed as advice meeting the particular investment needs of any investor, and they are not intended to serve as the primary basis for financial planning or investment decisions. This material has been prepared for informational purposes only and is not a solicitation or an offer to buy any security or instrument.