Morningstar Advisor - December 2013/January 2014 - (Page 26)

In Practice How to Manage Bonds for Today and Tomorrow By Marta Norton Past unlikely to be repeated, but exposure to credit-sensitive and inflation-hedging sectors could minimize rising-rate damage. With the 10-year Treasury yield hovering around 2.5% and a spring rout still fresh in investors' minds, conventional wisdom seems to hold that higher rates will decimate bond prices. But does history bear that out? In this article, we review historical interest rate and performance data to evaluate the impact rising rates have had on the bond market in years past under a variety of conditions. We then discuss the strategies we believe will be most effective in protecting capital if and when interest rates move higher. Our Approach To conduct our analysis, we compile yield and return data for the Ibbotson Associates SBBI Intermediate-Term Government Bond Index covering every month from January 1946 through September 2013. Using that data, we pinpoint consecutive multimonth periods in which yields rose more than 10 basis points and then calculate the index's total return during those periods. We choose the Ibbotson index for a few reasons. First, we are trying to isolate the impact of rate changes spurred by rising real yields and evolving inflationary expectations, not widening credit spreads, making a government bond benchmark most suitable. Second, the index targets a five-year maturity, which makes it a rough proxy for the interest-rate sensitivity of 26 Morningstar Advisor December/January 2014 "core" portfolios. Third, the Ibbotson index extends back nearly seven decades, a track record that's particularly useful given the different interest rate regimes seen in the post-World War II period. The Results We find there were 64 multimonth periods in which the Ibbotson index's yield climbed more than 10 basis points. The magnitude of rate increases range from a minimum of just 16 basis points to a maximum of more than 468 basis points, with a median increase of 94 basis points Similarly, the rising-rate periods vary significantly in terms of length, ranging from as little as two months to as many as 21 months, with a median length of about five months. Despite popular belief to the contrary, rising rates are not an albatross for the Ibbotson index's performance, at least when viewed in a certain light. Indeed, when we sort by return, we find the index ekes out a nominal return of 22 basis points during these periods, which is hardly the bloodbath some might have expected. However, some important caveats apply. For one, there is a pretty wide disparity of returns, ranging from a 5.53% cumulative nominal loss (September 1993 to December 1994 when rates rose 297 basis points) to a 5.87% cumulative nominal gain (November 1976 to June 1978, when rates rose 250 basis points). In addition, the median after-inflation return is nothing to write home about- a 1.49% cumulative loss. In other words, rising-rate periods aren't interchangeable- we find a bond investor's experience could differ significantly based on factors specific to the rising-period concerned, such as the level of prevailing yields and inflation. Drilling Down Given that the headline figures don't necessarily tell the whole story, we drill-down further to better identify telling similarities and differences between various rising-rate periods and subsequent bond returns. We assign each of the 64 rising-rate periods to one of four groups based on the level of yields that were prevailing at the time the rate increase began: prevailing yields below 4%, between 4% and 8%, between 8% and 12%, and 12% and greater. Then, within each yield group, we break down the rising-rate periods further based on the inflation rate experienced in the 12-months immediately preceding the rising-rate periods concerned. We use four inflation groupings for this purpose: 12-month inflation less than 2%, between 2% and 4%, between 4% and 8%, and 8% or more. Thus, there are 16 distinct groups (four yield groupings times four inflation groupings)

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

Morningstar Advisor - December 2013/January 2014
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