What do rising rates mean for bond investors? Particularly in regard to target-date funds in plan investment lineups, we are often asked: What should plan sponsors do (if anything) to minimize the impact of rising interest rates, especially for participants in or near retirement?
One “solution” (suggested mostly by active fund managers) is to use active management for the bond portion of the portfolio. The argument goes that active funds are better in a rising rate environment because they can shorten their duration, reducing losses from rising rates. What they don’t point out is that for this strategy to work, the manager has to get four things right: when rates go up; how much rates go up; the shape of the yield curve; and when rates stop going up. A miss on any of the four can turn a possibly successful strategy into a losing one. That’s a lot to get right, or looked at another way, a lot that can go wrong.
So, how good are active managers at forecasting the bond markets? According to Vanguard research,¹ they aren’t very effective. Regardless of the type of bond fund we looked at (corporate or government) or the duration tilt (short or intermediate), in the vast majority of rising rate environments from 1981 to 2015 (1986 to 2015 for short term bonds), active bond managers underperformed their benchmarks (Figure 1).
Figure 1. Active bond funds often underperform their benchmarks
Percentage of short-term funds underperforming
Note: The yellow horizontal line on the graph represents the point at which 50% of active short-term bond funds have underperformed their benchmarks. Vertical bars above this line indicate that more than half of active managers in this category underperformed their benchmarks for that time period. Vertical bars that fall below the yellow horizontal line mean that less than 50% of active funds underperformed their benchmarks in this category.
Percentage of intermediate-term funds underperforming
Note: The yellow horizontal line on the graph represents the point at which 50% of active intermediate-term bond funds have underperformed their benchmarks. Vertical bars above this line indicate that more than half of active managers in this category underperformed their benchmarks for that time period. Vertical bars that fall below the yellow horizontal line mean that less than 50% of active funds underperformed their benchmarks in this category.
Sources: Vanguard, based on fund returns from Morningstar, Inc., and index returns from Barclay’s Capital. Funds include those that liquidated or merged during the identified time periods. Short-term government funds are compared with the Barclay’s Capital U.S. 1-5 Year Government Index. Short-term corporate funds are compared with the Barclay’s Capital U.S. 1-5 Year Credit Index. Intermediate-term funds are compared with the Barclay’s Capital U.S. Aggregate Index.
In our analysis, we used prospectus benchmarks, rather than style benchmarks. This stacks the deck in active management’s favor, because it ignores style drift and benchmark overweights. For example, active managers who outperformed their funds’ respective benchmarks because they included high-yield bonds in their investment grade portfolios were classified as outperforming. So our analysis should provide a favorable environment for active managers to outperform. But despite this built-in advantage, active management still underperforms much more often than it outperforms, especially when short-term rates are rising.
The chart below shows both the 2-year Treasury yield and the 10-year Treasury yield since 2012, and how active bond managers performed against their indexes. Whether the rate increases were limited to short-term or intermediate-term rates (or both), active managers consistently underperformed in our analysis, even though we stacked the deck in their favor.
Figure 2. Percentage of active funds underperforming in rising-rate environments
Source: Vanguard, based on data from Morningstar, Inc.
Source: Vanguard, based on data from Morningstar, Inc.
So, if active management isn’t the answer, what is? Time and patience. Rising rates benefit bond investors by increasing yields. And, over time, the initial principal loss is recovered as the bonds in the portfolio move closer to maturity. The trick is to let time and patience do their work so you don’t miss out.
Few battles are won without a strategy, and passively managed target-date funds act as the generals, crafting and executing the dual strategies of asset allocation and rebalancing. Once your strategy is in place, your “warriors,” time and patience, can fight the battle against rising rates.
“The strongest of all warriors are these two–Time and Patience”
-Leo Tolstoy, War and Peace
I’d like to thank Garrett Harbron and Josh Hirt of Vanguard Investment Strategy Group for their invaluable contributions to this blog.
¹Philips, Christopher B., and Walker, David J., 2011. Rising rates: A case for active bond investing? Valley Forge, Pa.: The Vanguard Group.
- All investing is subject to risk, including the possible loss of the money you invest. Diversification does not ensure a profit or protect against a loss.
- Past performance is no guarantee of future results. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index.
- Investments in bonds are subject to interest rate, credit, and inflation risk.
- Investments in target-date funds are subject to the risks of their underlying funds. The year in the fund name refers to the approximate year (the target-date) when an investor in the fund would retire and leave the workforce. The fund will gradually shift its emphasis from more aggressive investments to more conservative ones based on its target date. An investment in target-date funds is not guaranteed at any time, including on or after the target date.