What Would Happen When Interest Rates Go Up

By now you probably heard that bonds, and in particular long-term US Treasury bonds, did the best in 2011 among all major asset classes. Here are the performances of select Vanguard mutual funds in 2011:

Vanguard Long-Term Treasury Fund (VUSTX) +29.28%
Vanguard Long-Term Bond Index Fund (VBLTX) +22.06%
Vanguard Long-Term Investment-Grade Fund (VWESX) +17.18%
Vanguard Inflation-Protected Securities Fund (VIPSX) +13.24%
Vanguard Intermediate-Term Treasury Fund (VFITX) +9.80%
Vanguard Total Bond Market Index Fund Admiral (VBTLX) +7.69%
Vanguard Total Stock Market Index Fund Admiral (VTSAX) +1.08%
Vanguard Total Int’l Stock Index Fund Admiral (VTIAX) -14.52%
Vanguard Emerging Markets Stock Index Fund Admiral (VEMAX) -19.05%

The great returns from bonds came from capital gains, not bond interest. For instance, of the 29.28% return from Vanguard Long-Term Treasury Fund (VUSTX), 25.11% was capital gains. The income return was only 4.17%. If it gained 25% in one year because interest rates went down, can it give it all back (lose 20%) in another year when interest rates go back to what it had been before?

Of course it can. That’s just how bond math works. If you benefited from capital gains when interest rates went down, be ready to relinquish those gains when the reverse happens. For all the flak Bill Gross got for bailing out of Treasuries too soon, if you did the same, it may not be that bad after all over a full cycle: you missed the gains but you will also miss the reversal, provided that you don’t lose your resolve and chase the performance after a huge price run-up.

It’s the same for gold. If you missed the gains in gold, no big deal. You will also miss the reversal down the road.

If you invested in a broadly diversified, intermediate-term bond fund, for instance Vanguard’s Total Bond Market Index fund, bad news. You missed the the gigantic gains in 2011. Instead of earning 25% in capital gains in a long-term US Treasury bond fund, you earned only 4.3% in capital gains. When added to a 3.4% return from interest income, you got a 7.7% total return. It’s still much better than the returns from stocks, but it’s also a far cry from the 29% return from long-term Treasuries.

The good news is that because you didn’t really benefit much from capital gains in a broadly diversified, intermediate-term bond fund, you won’t have to give back much when a reversal happens. Investment advisor Rick Ferri wrote Fears of Soaring Rates are Overblown, although he also called the situation in Treasury bonds a bubble.

"Today, the global credit crisis has caused a Treasury bond bubble."

He estimated that a broadly diversified intermediate-term bond fund such as Vanguard Total Bond Market Fund (VBTLX) will have a 0% nominal return over a 3-year period, maybe starting around 2014.

Whether this means that fears of soaring rates are overblown is subjective. I would think a 0% nominal return over a 3-year period is bad enough already. Why would you want a 0% return over a 3-year period when you can get a positive return elsewhere?

If Rick Ferri’s estimate is correct, it would make sense to buy a 5-year CD. The 5-year CD will have the same or higher yield than the bond fund in the first two years. When the bond fund earns zero in the next three years, the CD will still earn the same positive 2.x% yield.

According to DepositAccounts.com, at this time some places for a good 5-year CD include Melrose Credit Union (2.68%) and Pentagon Federal Credit Union (2.25%). Both credit unions accept members nationwide.

I also wrote about some other fixed income choices a short while ago in What to Do When Interest Rate Is So Low.

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  1. Investor Junkie says

    CDs and CD like options are less risky than bonds.

    I personally think there are some better deals with dividend paying stocks.

  2. nickel says

    “if you did the same, it may not be that bad after all over a full cycle: you missed the gains but you will also miss the reversal”

    The same can be said of sitting tight, right? Sure, you might get pounded on the way down, but you enjoyed the ride up.

  3. Harry Sit says

    @nickel – Yes, the same can be said about sitting tight. You already got some surprise gains. You can afford to give them back. If someone was prescient or lucky enough to be in long-term Treasuries in 2011, I don’t blame them for wanting to take some money off the table. That’s rebalancing: buy low, sell high.

  4. nickel says

    TFB: Absolutely. If the gains have knocked your allocation out of whack, then you should do the prudent thing and rebalance.

  5. dd says

    Nickel, sitting tight is not all it seems. For example: 100K goes down by 50% and then goes up 50%. You have 75K. If you rebalance at the low point with funds in other areas then you can enjoy the ride up and perhaps be at the same point of 100K.

  6. nickel says

    dd: Agreed, but that doesn’t really address what we’re talking about here. In this case, if you had sat tight, you would’ve enjoyed a 20%+ gain before any decreases associated with an eventual rate increase.

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