Back in February I wrote a blog about whether or not it makes sense to avoid bonds today (https://www.cognizantwealth.com/2013/02/14/should-you-avoid-bonds-in-todays-environment/). My conclusion was that bonds remain a critically important part of an investment portfolio, but that bond buyers need to be more selective in the current environment.  Last month the Fed announced that it is considering phasing out its four-year interest rate suppression program – more popularly known as Quantitative Easing – sometime next year since the economy appears to be picking up steam.  The result was an unprecedented spike in bond yields – and consequent drop in prices – together with outflows of some $80 billion from bond mutual funds.  (The latter was significantly higher than the bond fund outflows at the peak of the Great Recession panic in 2008).

Really?  What investor could not possibly have known that at some point the Fed would stop quantitative easing?  Or that interest rates are going to rise?  Yet the investment community reacted with what amounted to shock and dismay.  What can we learn from this?

The first lesson is that very few investors appear to have read my blog.  The second is that behavioral finance psychologists have got it right.  Human beings do not make investment decisions rationally and in their own best interests, unlike what the Efficient Market Hypothesis (EMH) posits.  Something very normal occurred, yet investors reacted as if it was totally unexpected. And by pulling so much money out of bond funds, what are they now going to do with it?  Invest it in the money markets (with an annualized return of about 0.25%)?  Pour it into stocks (with a cyclically adjusted PE ratio of 23)?  Psychologists will tell you that one action based on emotion rather than logic will usually lead to another.

In fact, there is something very simple that bond investors can and should be doing to protect their portfolios from interest rate risk.  It is to reduce the durations of their holdings.  What is duration?  It’s a measure of how strongly a bond’s price will change based on interest rate changes.  When interest rates go up, the prices of bonds with longer durations will drop more than those with shorter durations. The downside, of course, is that returns from shorter duration bonds tend to be lower than from those with longer durations.  But in general, bonds aren’t expected to provide the majority of returns in a portfolio.  They’re primarily there to diversify and to stabilize it.  And numerous studies have shown that over time, the main source of returns from bonds (and even bond funds) are from the interest paid on the bonds, not from changes in their prices.  According to one study by The Brandes Institute, interest payments accounted for over 90% of five year bond returns on average since 1926.

What can we expect to happen to bond funds over the long run?  It depends on the pattern of rate increases over time.  Each time rates rise, fund prices will fall.  Then, as the funds sell older bonds and buy newer ones, the higher interest payments will generate more income for the fund holders.  This zigzag return profile should exhibit a positive trend over time as the higher interest income exceeds the capital losses from the sold bonds.  If you are holding longer duration bond funds performance is apt to be quite volatile, but if you stick to lower duration holdings the path should probably not be too bumpy.

As I indicated in my earlier blog, duration is not the only factor you should be considering when investing in bonds.  There are also many different types of bonds that respond differently to interest rate changes.  You can invest in floating rate loans, for example, which rise as interest rates do but which have more credit risk since the borrowers tend to be companies that are not qualified to raise more traditional fixed-coupon bonds.  Regardless, the bottom line is that selling your bonds at the first sign of a rise in interest rates is probably not going to result in the investment performance on which you are planning for the rest of your life.