Recently the market has yielded fantastic returns for equity investors. As valuations for equities increase, many have sold their stocks and raised cash. Fearing increases of record low interest rates could cause negative returns; many have been reluctant to move their cash into fixed income instruments like bonds. These fears have been realized over the past eight months as long-term interest rates have increased dramatically and caused bonds to plummet in value.
The chart above is a 6.13% 40 year CenturyLink bond that was publicly offered in May 2013. At the time, rates were near all time lows. However, over the past eight months rates have increased dramatically causing the value of the bond to decrease. An initial investment of $100,000 in May would now only be worth $81,200 plus about $3,600 in paid interest.
Purpose and Assumptions
In my experience, one of the hardest concepts for investors to grasp is the effect of interest rates on their investments. Investors know rising interest rates can lead to fixed income losses, but many don't fully understand the magnitude of the effect. In some rising rate scenarios, the interest payments actually dominate the capital loss, leaving investors better off. The purpose of this writing is to compare cash and fixed income under three interest rate scenarios to help investors understand how rising rates affect returns. For simplicity, the following assumptions are made:
- Any interest is paid and reinvested at the end of the year.
- There is no change in credit rating or worthiness of the issuer.
- Interest rate shifts will be the same across the assets (except in the market scenario).
- No inflation.
The Two Investments
- Cash: For purpose of the analysis we will assume cash pays a comparable interest rate to a one month T-Bill.
- CTY (CTY): An exchange traded 40 year bond from telecommunications company CenturyLink (NYSE:CTL). The bond currently yields about 7.6% and has investment grade ratings by both Moody's (Baa3) and S&P (BBB-).
Scenario One - The Market Scenario
Scenario one is the current market projection (based on forward rates) of returns for both investments over the next ten years. It is created by deriving the implied forward treasury rate curve and applying the rate increases to cash and CTY. The implied forward treasury curve is the market's expectation of interest rates in the future. For the cash investment, the one month T-Bill rate each January for the next ten years is used. For CTY, the rate change in the 20 year treasury each January is applied to the current CTY yield.
As you can see by the graph, an investor is better off at every point on the curve investing in CTY. There will be some capital loss as rates move higher, but this loss is dominated by the higher interest received and reinvested each year. Despite rising interest rates every year the superior investment is CTY.
Scenario Two - Rates Rise Faster
Scenario two assumes much larger rate increases (1% a year) for the next six years followed by rate stabilization.
Under this scenario the effect of the higher rates on CTY is clearly illustrated. Unlike scenario one in which the interest component dominates the capital loss on the bond, the rate increases here are higher. As rates increase, the capital loss on the bond keeps returns depressed relative to cash until rate stabilization in year six. Investors may be better off holding cash in this scenario unless they plan on holding long-term.
Scenario Three - Rates Shocked Higher
Scenario three assumes rate shocks of +3% each of the first two years followed by rate stabilization.
The effect of the rate shock is very severe on CTY returns in the early years. The much higher rates cause large decreases in the price of the bond leading to large capital losses. As rates stabilize CTY begins to catch up, and eventually passes the cash return. However, investors would realize large losses if they were forced to sell within the first few years.
The decision to invest in fixed income depends on an investor's specific circumstances. However, it is imperative to understand how market fluctuations of factors such as interest rates can affect magnitude of returns. This article outlines only one type of risk, interest rate risk of holding a corporate bond. Investors should also educate themselves on liquidity, default, and inflation risk before considering any fixed income investment.
Investors comfortable with these risks should note the recent increase in long-dated rates has created a better risk/reward environment for holding bonds over cash. Cash continues to pay rates near zero while long-dated fixed income rates have increased dramatically. Although scenarios two and three outlined above are possible, I consider them near worst case scenarios for long dated fixed income. Assuming comparable treasury to investment grade spread, a 13.6% yield on an investment grade bond translates into a ten year treasury of near 9%, a rate not seen in almost three decades. Even under worst case scenarios, the return on fixed income is still greater than cash if the investment is held long enough (6-7 years). Investors should not let rising rates necessarily scare them away from fixed income.
Additional disclosure: I am long CTY.