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IMA Tax Policy Blog

Why Hold Bonds in a Bond Bear Market?

by Jim Baird and Tricia Newcomb

Plante & Moran, PLLC is an IMA Member

Since 1981, the long-term trend for interest rates in the U.S. has been downward, increasing bond prices and enhancing overall fixed income returns. However, recent increases in interest rates have some calling for the end of the 30-year bond bull market and wondering what a long-term bond bear market would actually mean for fixed income returns.

As the chart illustrates, price fluctuations have had little impact on overall returns for long-term fixed income investors. Since the start of the bond bull market in 1981, less than 4% of the cumulative returns of the Bloomberg Barclays U.S. Aggregate Bond Index were a result of price appreciation due to falling interest rates. The vast majority of returns (96%) have come from bond coupon payments – the stable source of income that bonds are known for.

If we are indeed entering a new period of generally rising interest rates, the mark-to-market price of bonds will tend to fall as interest rates edge higher. However, these price fluctuations are of little consequence for long-term investors who own high-quality bonds with low default risk, as investors are expected to receive their principal in full at maturity. Moreover, investors who hold high-quality bonds over a long-term horizon can take advantage of the reinvestment of coupons and maturities at higher prevailing interest rates, resulting in a higher income component over time and thus higher returns over a longer time horizon. While a so-called bond bear market would likely create greater short-term price volatility, the role bonds play within a portfolio with some degree of risk aversion has not changed. They provide a consistent income stream, act as a safety net in risk-off environments, and enhance overall portfolio diversification.

 

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