With interest rates increasing and clients raising concerns about their bond holdings, advisors should look at the performance of various asset classes during past periods of long-term rises or declines.

In the Rise & Fall of Fixed Income chart below, various fixed-income indexes are measured during periods of rising interest rates (1977-1981 and 2002-2006) and periods of falling rates (1982-1986 and 2007-2012).

During the five-year period from 1977 through 1981, the federal discount rate rose to 13.42% from 5.46%, an increase of nearly 800 basis points, or 145.8%. During that period, the five-year annualized return of U.S. T-bills was an impressive 9.84%.

But bonds did not fare nearly as well. The Barclays one- to five-year government/credit index had a five-year annualized return of 6.61%, while the intermediate government/credit index had a 5.63% annualized return. The long government/credit index got hammered amid the rising rates, and ended the five-year period with an annualized return of -0.77%. Finally, the aggregate bond index had a five-year annualized return of 3.05%.

In 1982, however, interest rates (as measured by the federal discount rate) began to fall, dropping from 13.42% at the end of 1981 to 6.33% by the end of 1986 - a decline of 709 basis points, or nearly 53%. During this period, T-bills had a five-year annualized return of 9.08% - very impressive by today's standards. The five-year annualized returns of the various Barclays government bond/credit indexes flourished: 14.63% for the one- to five-year index, 15.91% for the intermediate index, 22.85% for the long index and 18.42% for the aggregate bond index.

As every planner knows, bond performance improves when interest rates are declining. But it is worth noting that while the performance of the intermediate index was lower amid the rising rates of 1977 to 1981, it wasn't horrible. An annualized return of 5.63% is quite good when rates are increasing. On the other hand, the long government/credit index was not the place to be when rates were rising - but when they fell, its performance was stellar.



The next period of rising interest rates was from 2002 to 2006. During this five-year period, the federal discount rate had a fivefold increase: from 1.17% to 5.96%. T-bills returned 2.64%; the one- to five-year index, 3.77%; the intermediate index, 4.53%; the long index, 7.38%; and the aggregate bond index, 5.06%. The long index's performance is surprising considering its performance during the 1977-1982 period.

During the past six years (2007-2012), as the federal discount rate declined from just less than 6% to less than 1%, the performance of the various bond indexes was, as expected, better than during the previous five years - but the differential was not significantly better. This seems to suggest that bond indexes (and the mutual funds and ETFs that track them) are generally sensitive to changes in interest rates, but the connection is not always as pure as the theory would suggest.

Another important aspect of rising rates is the positive impact they have on "cash," which refers to savings accounts and CDs, as well as money-market mutual funds and accounts. Cash is the ultimate safe haven, at least in nominal terms. If rates rise, the return on cash will inch back closer to its historical annual average of about 5.6% (from 1970-2012).



It is also worth noting how other asset classes (U.S. and non-U.S. equities, real estate, commodities) performed during these same up and down interest rate cycles. The results are shown in the Equities & Diversifiers During the Rise & Fall chart below.

In general, the connection between movement in interest rates and the performance of these other asset classes is far less clear than what we observed in the bond indexes. The five-year period from 2002 to 2006 may represent a time frame that has some similarities to the current period, with low rates likely increasing near term. During that period, large-cap U.S. stocks (as measured by the S&P 500) averaged a bit more than 6% annual growth; small-cap U.S. stocks (Russell 2000) more than 11%; non-U.S. stocks (MSCI EAFE) nearly 15%; real estate (Dow Jones U.S. Select REIT) almost 24%; and commodities (S&P GSCI) nearly 15%.

The previous period of rising rates was 1977 to 1981, when large U.S. stocks had a five-year annualized return of more than 8%, small-cap U.S. stocks gained more than 25%, non-U.S. stocks 14.5%, REITs 26% and commodities 10.7%.

If the U.S. economy faces increasing rates over the next several years, and core asset classes perform similarly to previous periods of rising rates, the outlook is rather encouraging - at least for investors who stay diversified. This really is the key. The performance of any particular asset class - fixed income, pure equity or a diversifier - cannot be predicted accurately. (If it could, we all would have been in cash in 2008.)

Analyzing the data demonstrates that fixed income (as measured by various bond indexes) is more sensitive to movement in interest rates than equity indexes, real estate or commodities. Nevertheless, even during times when interest rates were rising (1977-1981 and 2002-2006), the performance of certain bond indexes was surprisingly strong.

In general, it seems safe to conclude that when interest rates rise, it is prudent to use bond indexes (via either mutual funds or ETFs) that have shorter durations, since longer-duration bond funds are more susceptible to losses.

But one important note: It does not seem prudent to avoid bonds entirely during periods of rising interest rates. Bonds are a vitally important part of a diversified portfolio containing a wide variety of asset classes - during all times and seasons. Rather than trying to decide whether to be in or out of bonds, the more relevant issue would seem to be whether to use short-duration or long-duration bonds.

This, of course, is consistent with a strategic approach to portfolio design. Rather than completely remove an asset class from a portfolio, advisors and clients would be well advised to thoughtfully modify the components of an asset class. To use a nautical metaphor, rather than swapping boats, we simply trim the sails.



Craig L. Israelsen, a Financial Planning contributing writer in Springville, Utah, teaches in the personal financial planning program at Utah Valley University's Woodbury School of Business. He is also the developer of the 7Twelve portfolio.

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