Morningstar Advisor - December 2013/January 2014 - (Page 27)

to which a given rising-rate period could have been assigned. Our first pass through the data suggests that, regardless of prevailing yield level or inflation rate, nominal returns remained roughly flat during periods of rising rates (Exhibit 1). For example, in the two instances in which prevailing yields are below 4% and inflation is 8% or above, the median cumulative nominal return is 67 basis points. In the three instances in which the prevailing yield is between 8% and 12% and inflation is 8% or greater, the median cumulative nominal return was a 49-point loss. A change of sign to be sure but hardly a significant move. However, the same cannot be said of real returns. Indeed, the lower prevailing yields are at the beginning of a rising-rate period and the higher inflation is running in the 12-months preceding that rising-rate period, the worse real returns tend to be. For example, when prevailing yields are below 4%, rising rates almost invariably lead to negative real returns, which grow dramatically worse during periods of higher inflation. By contrast, when yields are 4% and above, real losses tend to be less severe, regardless of the inflationary environment. This makes intuitive sense. At low yields, the index has less income to offset the real price decline that results from rising rates and high inflation only compounds the problem. At higher prevailing yields, however, the index has a fatter cushion to sustain rate-associated losses and withstand the bite even very high inflation can take out of its returns. Of course, not all rate increases are created equal, as a 50-basis-point rate move looms larger when prevailing yields are sitting at, say, 3% than when they're hovering around 10%. With that in mind, we perform a variation of the previous analysis, but this time considering the magnitude of the rate change relative to the prevailing yields at the beginning of each rising-rate period. (In other Exhibit 1 Yield, Inflation at Beginning of Rising Rate Period January 1946 through September 2013 Prevailing Yields at Time of Rate Increase Less than 4% 4% to 7.9% 8% to 11.9% 12% and greater Median Nominal Return (%) 12-Month Inflation at Beginning of Period Median Real Return (%) Median Nominal Return (%) Median Real Return (%) Median Nominal Return (%) Median Real Return (%) Median Nominal Return (%) Median Real Return (%) 0.21 -0.27 0.32 -0.08 - - - - 2% to 3.9% -0.18 -0.60 0.48 -0.57 -1.15 -3.11 - - 4% to 7.9% -1.22 -2.25 0.00 -2.41 1.64 -1.11 - - 0.67 -4.50 1.46 -2.72 -0.49 -3.14 2.51 0.82 Less than 2% 8% and greater Table shows returns of the Ibbotson Associates SBBI U.S. Intermediate-Term Government Index. words, we divide the rate increase by the index's yield at the beginning of each rising rate period.) What we find is pretty stark (Exhibit 2). When the rate move accounts for less than 10% of the index's prevailing yield, the index tends to hold steady, even after accounting for inflation. However, when it accounts for 20% or more, real returns fall off, sometimes dramatically. And the higher inflation runs, the more damage the rate increases tend to inflict on the index's real returns. returns will be horrible, at least in the event of a near-term rate rise. On the other hand, rates likely wouldn't have to jump by much before the magnitude of the move represented a large percentage of the current 1.06% yield. If history is any precedent, that could prove fairly damaging to bond returns, at least in the short run. Consider this past spring, when the Ibbotson index dropped 234 basis points between May and the end of June due to a 53-basis-point move in rates. Furthermore, should inflation surprise on the upside, any rate spike would likely be all the more painful. What Does This Tell Us about Today? The current bond market environment is characterized by both low yields and low inflation. On Sept. 30, 2013, the Ibbotson index was yielding 1.06%, which was 396 basis points below its historical median. Meanwhile, the 12-month annual inflation clocked in at 1.5% as of August 2013, suggesting our economy has experienced inflation below the historical average over the past year. This is good and bad news. On one hand, real returns tend to be poorest when recent inflation is high, yet inflation has been remarkably subdued in recent years. Thus, bond investors could draw some sustenance from the low-inflation climate in which they find themselves, which makes it less likely that Managing Through Rising Rates The question then becomes how to manage the bond portion of a portfolio in the event rates do in fact rise. For many, the obvious course of action is to sell bonds altogether and buy back in when rates are higher, thereby avoiding the losses and later benefiting from higher yields. While tempting, we think this could prove a mistake. For one, rates may not rise for quite some time. As a result, investors who sit in cash could ensure they earn less than inflation while they wait. Those who turn to the equity market, meanwhile, may find they experience more volatility in the interim than is appropriate for their risk tolerance. Second, rate moves are extremely difficult to predict. Regardless of where investors put their MorningstarAdvisor.com 27 http://www.MorningstarAdvisor.com

Table of Contents for the Digital Edition of Morningstar Advisor - December 2013/January 2014

Morningstar Advisor - December 2013/January 2014
Contents
Contributors
Letter From the Editor
What’s Your Purpose?
Working for Gen Y
How to Allocate College Savings
Mobius Looks to a New Frontier
Investments á la Carte
Investment Briefs
How to Manage Bonds for Today and Tomorrow
Cloud Is the New Engine of Growth
Knowing Where to Look
Economic Vulnerability Varies by Country
Factor Investing in Emerging Markets
Following the Rules
Exploring Indexing’s Next Frontiers
Frequent Fliers
Family Blind Spots
Optimal Portfolios for the Long Run
Finding Value in a Pricey Sector
Our Favorite Mutual Funds
50 Most-Popular Equity ETFs
Undervalued Stocks With Wide Moats
The Emerging-Markets Roller Coaster

Morningstar Advisor - December 2013/January 2014