At the start of this year, many people told me they didn’t want bonds. That’s because bonds and bond funds lose value when interest rates rise, and rising rates seemed like a sure thing.
The Federal Reserve late last year signaled three rate hikes for 2017, and nearly all of the 64 economists surveyed by the Wall Street Journal in January predicted increases in the 10-year Treasury by the end of June. With that sort of overwhelming consensus, it’s no wonder people were so skittish of bonds.
Fast forward to today. Fed policymakers on Wednesday raised its benchmark rate by a quarter-point, the second such increase this year. And even though this was widely anticipated, the yield on a 10-year Treasury stood at 2.11 percent in the early afternoon, down from 2.45 percent at the end of December. And an intermediate-term bond fund like the iShares Core U.S. Aggregate Bond ETFs, which holds investment grade debt mostly from the U.S. government, has returned 3 percent so far this year. Part of the return came from falling rates that cause bonds and bond funds to go up in value.
Why didn’t these bond rates rise? First, understand that the Federal Reserve controls the Fed Funds Rate, which is a rate that banks charge each other for overnight loans to boost cash reserves. Bond rates, however, are influenced by longer term rates, such as the 10-year Treasury, that are set by the market.
Economists’ forecasts of the direction of 10-year rates so far have been wrong, and that’s nothing new. According to the New York Times, economists overstate rates again and again. This is consistent with other studies showing poor forecasts of those rates. How is it possible to be so consistently wrong? Because at the start of the year, the rate already took into account the expectations of what the Fed and the economy will likely do later. So unless new information comes to light, rate forecasts are typically behind the times
What this means to your investing
Don’t be naive in thinking it’s so easy to predict how bonds will do. Data from Chicago-based research company Morningstar demonstrates we move in and out of bonds at the wrong times, resulting in the average investor underperforming the bond funds themselves. A better approach would be to pick a high quality intermediate-term bond fund like the iShares fund previously mentioned or the Vanguard Total Bond Fund (BND). Then ignore the forecasts and stick to your investments, selling only to rebalance to your target asset allocation.
If economists finally do get it right and rates do rise, keep the silver lining in mind. As bonds in your bond fund mature or are sold, the fund will be buying new bonds yielding that higher rate. That means more income for you.
Finally, don’t ever reach for income. Stick to boring high credit quality bonds. Lower credit quality bonds and bond funds tend to perform poorly when stocks tank. You want your bonds to perform well when stocks don’t.
Allan Roth is the founder of Wealth Logic, an hourly-based financial planning firm in Colorado Springs, Colo. He has taught investing and finance at universities and written for Money magazine, the Wall Street Journal and others. His contributions aren't meant to convey specific investment advice.