Commentary by Roger Aliaga-Díaz, Ph.D., Vanguard chief economist, Americas, and head of portfolio construction.

Investors may be feeling jittery about the near-term risk of investing in government bonds, as yields have risen (and prices fallen) over the past nine months in response to rising interest rate expectations. The yield on the 10-year US Treasury note rose more than 100 basis points (1 percentage point) from August 2020 to late March 2021 and yields on UK government bonds have also risen1.

In such market cycles, it’s particularly important to keep in mind the role that bonds play in a diversified investment portfolio—to be a shock absorber at times when equity prices head downward, as we explored in a recent blog.

In short, don’t let changes in interest-rate expectations drive a strategic shift in your bond allocation. Myths and misconceptions regarding bond investing abound during periods of rising rates, often coupled with calls for drastic changes to clients’ portfolios. Here are three common myths that investors should avoid:

Myth #1: “Go to cash, avoid duration risk”

Rising rates have hit long-term bonds the hardest. But the recommendation to avoid duration, or interest-rate risk, is backward-looking and probably comes too late. Investors should shift their mindset to a forward-looking view of the bond markets. The market consensus is that rates will rise, and the prices of short-, intermediate- and long-term issues already reflect that belief.

Today’s market prices for longer-term bonds already factor in investors’ expectations for rising rates, which is why prices are cheaper. If that consensus view were to play out, there would be no advantage in shifting to shorter-term bonds or going to cash. Such moves would pay off only if longer-term yields were to rise more than expected. However, it’s equally likely that yields will rise less than expected, in which case long-term bonds would do better.

Myth #2: “When interest rates are rising, don’t just stand there—do something!”

The recent stretch of rising rates was a surprise to the markets, but now markets expect continued increases. That rates are rising is not really news anymore. While yields indeed seem likely to rise, they may do so by either more or less than the market consensus.

With a 50/50 chance of rates rising more or less than consensus, a better approach than trying to pick which market segments will fare best in the near term is to stay well-diversified for the long term across the maturity spectrum and across asset classes.

Myth #3: “Bonds are a bad idea – abandon the 60/40 portfolio”

This common recommendation contradicts the overriding importance of maintaining a balanced allocation that suits your client’s investment objectives, plus it may be too late to gain any benefit from a tactical shift in asset allocation. Selling bonds after the recent increase in rates, which has driven down prices and total returns, is simply chasing past performance.

Investors should stay forward-looking. At current higher yields, the outlook for bonds is actually better than before yields went up. Bear in mind that the upside of higher yields – greater interest income – is coming. Also, the odds of future capital losses decline as yields increase. So now is not the time to abandon bond allocations. On the contrary, the more that bond yields rise (and prices fall), the more important it is for long-term investors to maintain a strategic allocation to bonds, which could require rebalancing into bonds, not the other way around.

Keep your eyes on the road ahead

It’s good advice in both driving and investing. Vanguard recommends that investors stay focused on long-term, forward-looking return expectations, not on recent trailing-return performance.

Let your client’s investment goals shape decisions about their strategic asset allocation. Calibrate the risk-return trade-off in their portfolios accordingly, including setting the right mix of bonds and stocks to meet those goals. And generally ignore market-timing advice, which is mostly based on public consensus information that is already priced into the markets.

Even if rates keep rising, long-term total returns on broadly diversified bond portfolios are likely to remain positive. That would be the natural outcome of reinvesting bond income at higher yields.

The elephant in the room – inflation

Inflation is often seen as the enemy of the fixed income investor, particularly unexpected inflation that the market hasn’t priced in. Inflation-indexed securities provide a limited hedge against unexpected inflation.

Vanguard research suggests that significant inflation hedging through inflation-linked securities requires large positions, which could reduce the other diversification benefits of a bond allocation in a portfolio. Over long time horizons, equities historically have provided the strongest safeguard against inflation2.

Where active can shine

A rising-rate environment also accentuates what skilled active managers may be able to bring to a bond portfolio. When yields are falling, outperforming fund managers pile their excess returns on top of the market’s generally rising prices. But amid the headwinds of rising rates and prevailing price declines, successful active fund managers may make the difference between positive and negative total returns.

Investors who are inclined to seek outperformance – and are aware of the risk of underperformance – can leave decisions about tactical shifts and security selection to professional active managers. Managers with a rigorous bottom-up investment philosophy and considerable local expertise—like my colleagues in our global credit team—can leverage their fundamental research capabilities to identify the opportunities where risk-adjusted returns are most attractive.

Find out more about Vanguard’s fixed income investment capabilities here. Yields on 10-year US, UK and Australian government bonds analysed between 1 January 2020 to 1 March 2021.

2 Bosse, Paul, 2019. Commodities and Short-Term TIPS: How Each Combats Unexpected Inflation. Valley Forge, Pa.: The Vanguard Group.

Investment risk information

The value of investments, and the income from them, may fall or rise and investors may get back less than they invested.

Past performance is not a reliable indicator of future results.

Funds investing in fixed interest securities carry the risk of default on repayment and erosion of the capital value of your investment and the level of income may fluctuate. Movements in interest rates are likely to affect the capital value of fixed interest securities. Corporate bonds may provide higher yields but as such may carry greater credit risk increasing the risk of default on repayment and erosion of the capital value of your investment. The level of income may fluctuate and movements in interest rates are likely to affect the capital value of bonds.

Important information

This document is directed at professional investors and should not be distributed to, or relied upon by retail investors.

This document is designed for use by, and is directed only at persons resident in the UK.

The information contained in this document is not to be regarded as an offer to buy or sell or the solicitation of any offer to buy or sell securities in any jurisdiction where such an offer or solicitation is against the law, or to anyone to whom it is unlawful to make such an offer or solicitation, or if the person making the offer or solicitation is not qualified to do so. The information in this document does not constitute legal, tax, or investment advice. You must not, therefore, rely on the content of this document when making any investment decisions.

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