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Special Report - Released 9/22/16

  • Troy Frerichs, CFA - Director, Wealth Management & Financial Planning
  • Jeff Clark, CFA, CFP® Manager, Investments & Wealth Management
  • Kent Anderson, CFA - Senior Investment Officer
  • Andy Finks, CFA - Investment Officer
  • Todd Bunton, CFA - Investment Officer
  • Chelsie Moore, CFA, CFP®Investment Officer
  • Jonathan Strok, CFA - Investment Associate 

Key Takeaways

  • Ultra-low interest rates are a headwind for the bond market, but fears of an imminent crash are likely overblown.
  • Historically, losses have been relatively minor for fixed income securities in a rising interest rate environment.
  • Even at low yields, bonds still offer investors attractive diversification benefits.

Back in the early 1980s, the Federal Reserve was in a difficult spot. The unemployment rate was higher than normal, but so was inflation, which was running in the double-digits. The Fed could lower interest rates to help drive unemployment down, but this would likely stoke even more inflation.

The central bank, led by Chairman Paul Volcker, decided instead to raise interest rates in an effort to beat inflation. The federal funds rate reached an astonishing 20%, and the yield on 10-year government bonds hit a record high of 15.8% in September 1981. The United States fell into a recession, with the unemployment rate reaching its highest level since the Great Depression. Despite repeated calls from Congress to ease its tight monetary policy, Chairman Volcker and the Fed held steady. The move eventually paid off. By the end of 1982, inflation had fallen below 5%, and the economy officially exited recession.

Since then, interest rates have fallen substantially. Today, the federal funds rate sits below 0.5%, and the yield on the 10-year Treasury note is hovering around 1.7%. This large and steady drop in rates over the last three decades has boosted fixed income prices, delivering strong returns to investors in the process. With yields now near historic lows, it appears that investors can no longer count on a consistently falling rate environment to lift bond prices. In other words, the nearly 35-year favorable environment for bonds could be coming to an end.

With interest rates so low, some have called for an imminent crash in the bond market. We believe that these fears are overblown. Today’s rate environment certainly provides some headwinds for fixed income securities, but the risks are likely not as great as some fear.

Historically, losses have been relatively minor for fixed income securities in a rising interest rate environment. Additionally, we do not expect rates to rise sharply here in the United States given extremely low, and even negative, yields in many places overseas. Finally, despite low yields, bonds still offer investors stability and downside protection relative to equities.

Figure 1


Rates Have Risen Before Without Dire Consequences

While it is well known that interest rates have fallen steadily since the early 1980’s, rates actually experienced several years of steady increases prior to that. How did the bond market perform in this rising rate environment? Not bad at all.

According to Fidelity Investments, the worst annual return for a synthetic index of intermediate government bonds and long-term corporate bonds from 1940 to 1980 was just -3.2% (Figure 1). That is certainly not a devastating loss. In fact, the average annual return for the index over this entire period was +3.4%. This compares favorably to the potential downside in the stock market as the S&P 500 index has declined -30% or more during severe bear markets.

There have also been a few periods since the early 1980s when interest rates have risen. In 1987, 1994 and 1999, the yield on the 10-year Treasury note jumped more than two percentage points from its lows the previous year. Yet, well-diversified bond portfolios held up relatively well. In fact, the Barclays U.S. Aggregate Bond index never lost as much as 3% in either of those years. During the “taper tantrum” of 2013, the yield on the 10-year Treasury note rose from a low of 1.40% in 2012 to more than 3%, but the Barclays index was down just -2% for the year.

While a falling rate environment is generally preferable, a rising rate environment is not uniformly bad for bond investors. In fact, longer-term investors can actually benefit from rising rates as they are able to reinvest their coupon and principal payments at higher yields over time. The impact of bond price fluctuations from a rising rate environment can be more than offset by staying invested over the long term.

Lower for Longer?

While it appears that rates have nowhere to go but up from these levels, there is no guarantee that rates will rise significantly anytime soon. In fact, relative to interest rates in many other developed markets around the globe, yields in the U.S. look attractive.

In an effort to stimulate their sluggish economies, central bankers in Japan and Europe have begun
experimenting with negative interest rates. These subzero yields are not just at the short end of the yield curve either. Yields are currently negative for 10-year government bonds in Switzerland and Japan and hovering around zero in Germany. These exceptionally low rates overseas could very well keep a lid on rates here at home as money flows in from global investors who want safety without a minus sign as a yield. Notice the strong correlation in 10-year government bond yields between the United States and other developed nations over time (Figure 2).

Figure 2

While the Federal Reserve continues to discuss raising interest rates if the U.S. economy improves, it is important to remember that the central bank only controls very short-term rates. Long-term yields, while influenced by short-term rates, are also impacted by other factors such as inflation, economic growth and overseas rates – all of which are currently below their historical averages. Long-term rates have been known to fall below short-term rates before, a condition known as an inverted yield curve.

Additionally, the Federal Reserve does not appear to be in a hurry to raise short-term rates. In December 2015, following its first interest rate hike in more than nine years, the Federal Open Market Committee projected that it would raise interest rates four additional times in 2016. As of late September, they have yet to hike once. This is not particularly surprising from the dovish FOMC. It has steadily reduced its projections for interest rates over time (Figure 3).

Figure 3

The Fed appears to be in no hurry to raise interest rates.

Bonds Still Have a Place

While we do not expect interest rates to spike anytime soon, we do expect bonds to deliver somewhat muted returns given the ultra-low interest rate environment. Based on our 10-year forecast, we estimate bonds will return between 2% and 4% per year. That is well below their recent historical average of 5 to 6%, but we do not believe that is a reason for investors to abandon bonds altogether.

Bonds still offer investors diversification benefits as they often have a negative correlation with stocks (Figure 4). As many investors saw at the beginning of this year, high quality bonds can provide a stabilizing force for portfolios when the stock market inevitably pulls back from time to time.


Figure 4


Fears of an impending burst in a “bond bubble” are likely overblown. Bonds have certainly benefitted from a tailwind of steadily falling interest rates over the last 35 years, and yields now look extraordinarily low. However, even in a low yield environment, bonds offer investors attractive diversification benefits. Additionally, rates have risen before without devastating losses in the bond market. There is also no guarantee that rates will rise significantly anytime soon, much less spike to Volcker-era levels.


The Barclays U.S. Aggregate Bond Index is an unmanaged index that covers the USB-denominated, investment-grade, fixed rate, taxable bond market of securities. The Index includes bonds from the Treasury, Government-Related, Corporate, MBS (agency fixed-rate and hybrid ARM pass throughs), ABS, and CMBS sectors. It is not possible to invest directly in an index.

The federal funds rate is the interest rate at which depository institutions lend reserve balances to other depository institutions overnight. The Federal Open Market Committee, which is the primary monetary policymaking body of the Federal Reserve, sets its desired target range.

The S&P 500® Index is an unmanaged index that contains securities typically selected by growth managers as being representative of the U.S. stock market.

Chart data comes from Thomson Reuters Datastream, a powerful platform that integrates top-down macroeconomic research and bottom-up fundamental analysis.


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All information is as of the report date unless otherwise noted.
Past performance does not guarantee future results. All investing involves risk, including risk of loss.

This material is provided for informational purposes only and should not be used or construed as investment advice or a recommendation of any security, sector, or investment strategy. All views expressed are based on the information available at the time of writing, do not provide a complete analysis of every material fact, and may change based on market or other conditions. Statements of fact are from sources considered reliable, but no representation or warranty is made as to their completeness or accuracy. Unless otherwise noted, the analysis and opinions provided are those of the COUNTRY Trust Bank investment team identified above and not necessarily those of COUNTRY Trust Bank or its affiliates.

Stocks of small-capitalization companies involve substantial risk. These stocks historically have experienced greater price volatility than stocks of larger companies, and they may be expected to do so in the future.

Stocks of mid-capitalization companies may be slightly less volatile than those of small-capitalization companies but still involve substantial risk and they may be subject to more abrupt or erratic movements than large capitalization companies.

International investing involves risks not typically associated with domestic investing, including risks of adverse currency fluctuations, potential political and economic instability, different accounting standards, limited liquidity and volatile prices.

Fixed income securities are subject to various risks, including changes in interest rates, credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications and other factors. Debt securities typically decrease in value when interest rates rise. The risk is usually greater for longer-term debt securities. Investments in lower-rated and nonrated securities present a greater risk of loss to principal and interest than higher-rated securities.

Diversification, asset allocation and rebalancing do not assure a profit or guarantee against loss.

All indexes are unmanaged and returns do not include fees and expenses associated with investing insecurities. It is not possible to invest directly in an index.