How to invest with interest rates so low

(MoneyWatch) One thing I'm asked about most often is what to do about bond investing in an environment of historically low interest rates. Not only are the yields painfully small -- the 10-year bond pays a mere 1.76 percent -- but low rates have led many investors to conclude that rates are sure to rise. In response, many investors stick to short-term bonds, hoping to reduce the losses if rates climb. Here's why that strategy might be a mistake.

Before we begin, it's important to note that the market has the same information that you do. Thus, that information is already embedded in prices. We see that in the shape of the yield curve. While rates have been low for the past few years, the yield curve has been fairly steep -- longer maturities have higher yields. It's also important to understand that the higher yields incorporate not just the expectation of rising rates, but also a premium for taking the risk that rates will rise more than expected. The result is that even if interest rates rise, but they rise by less than is implied in the current yield curve, you would have been better off by owning longer duration bonds, aka "extending maturities."

Example

A simple example illustrates this point. (We'll ignore the effect of compounding to keep the math simple.) An investor has a choice between:

Because of the fear of rising rates, he bought the one-year CD, and it turns out he was right about rates. The rate on a one-year CD increased 1.5 percentage points to 2.5 percent. Was he better off? If he had bought the two-year CD, he would have earned total interest of 4 percent. By investing in two consecutive one-year CDs, he earned 3.5 percent.

Historical data

The data in the table below, covering the period 1980-2011, brings this point home. The table shows the years the federal funds rate increased by more than 1 percentage point and the return on the Barclay's Intermediate Government/Credit Index in that year.

Only in 1994 did the federal funds rate rise by more than 1 percent and intermediate bonds lose money. In fact, over the last 36 years, we have seen a dramatic cyclical decline in interest rates. Yet, there were almost as many years when the federal funds rate increased (17) as there were years of decline. Yet, we only had one year (from 1973 through 2011) when the intermediate bond index produced negative returns.

Academic evidence

Craig Israelsen, associate professor at Brigham Young University, provided us with an interesting example. For the period 1976-2011, he created an annually rebalanced model portfolio that would allocate its bond holdings to cash during years when the federal funds rate rose. (It would stay an even split between bonds and cash when the federal funds rate fell.) The allocations were evenly split among:

I'm sure most people would be highly confident that the "perfect" timing portfolio would win by a large margin. Yet, the portfolio returned 10.65 percent, and the benchmark portfolio (which kept an evenly split allocation over the full period) returned a virtually identical 10.64 percent. Even with perfect foresight as to the direction of rates, a timing strategy failed.

The bottom line is that it's best to ignore all interest rate forecasts and stick to a disciplined plan, such as holding a bond ladder of about 10 years. That balances the dual risks of reinvestment (if rates fall) and inflation (which can cause rates to rise). Those who have done so, and ignored the forecasts of gurus, have been well rewarded. Those who paid too much attention to those forecasts paid the price in lost opportunity and reinvestment risk.

Image courtesy of Flickr user 401(K) 2012.

[markhenwood]

Larry, I grapple with this issue on an ongoing basis. If I want to stay ahead of inflation (as measured by break even inflation) on a after tax basis I have to go with maturities of about 10 years. This, of course, exposes higher inflation risk. Do you think it makes sense to revisit the big asset allocation question (FI v equities) when the FI component has zero or negative real return?

[LarryswedroeCBS]

Mark
As a good general rule it's best to have a plan (what is your average maturity) and stick to it. Exceptions might be made on margin as yield curve shifts. So if it steepens you might go bit longer and if flatter bit shorter. That is historically been good strategy for nominals.
With TIPS I would also consider real yield, when high go longer and lock them in, regardless of steepness of curve
The big mistakes people make in low rate environment are stretching for yield with worst mistake being taking credit risk or replacing bonds with higher yielding equity and less bad but still mistake is extending maturity (at least you keep credit quality and ensure return OF principal).
The more you are exposed to inflation risk the shorter your nominals should be and the more you should prefer TIPS, that's another factor. And you should also consider adding commodities as well, especially if buying longer term bonds.

I hope that is helpful
Larry

[LarryswedroeCBS]

Fractal
First, there is no one right portfolio. Just one right for you. If want to learn more about how to choose the right one read The Only Guide You'll Ever Need for the Right Financial Plan
Second, as general answer, the most efficient portfolios IMO are those that diversify across sources of risk/return---beta, size, value, momentum, and other sources potentially as well including carry trade, some arb strategies like merger and convertible arb (if can get at reasonable prices and done systematically and disciplined, not "active" management). Then diversify geographically as well. Should have perhaps 50% international of which 1/4 is EM.
The more you diversify the sources the better IMO. The best book on subject is by far Expected Returns by Anti Illmanen.

[FractalFin]

Larry, I noticed you quoted Craig Israelsen. What are some of your thoughts on his 7Twelve model for asset allocation?

Regards,

Peter

[carter4567]

How does this analysis apply to bond mutual funds?

[LarryswedroeCBS]

Carter
Bond funds are no different really than individual bonds though most investors think so. That' illusion, not reality. So you choose a bond fund that has the term and credit characteristics you want. For most investors I would suggest considering an intermediate fund with either only Treasury/Gov Agency or if corporate then only AAA/AA and no callable bond risk, meaning no MBS either.

Best wishes
Larry