Perspectives : Investment | June 30, 2023

Staying the course with bonds in a challenging rate environment

Read time: 8 minutes

As interest rates have climbed from near zero to their current level, retirement plan participants have seen the value of their bond portfolios drop, shining a light on duration and interest rate risk.  

Recent events have added to the climate of uncertainty. In 2022, participants saw the worst year for securities markets since the 2008 global financial crisis, according to data from Vanguard and Morningstar. With a simultaneous downturn in both stocks and bonds, some questioned the benefits of a traditional balanced portfolio. Meanwhile, a potential recession looms and company earnings are coming under pressure.

In this environment, it’s natural that some participants might be tempted to exit a sound, long-term investment plan and implement short-term tactical strategies, thinking they may mitigate losses or improve returns. For participants nervous about falling bond prices, this might mean favoring investments that can be more insulated from interest rate movements, such as cash or cash alternatives. However, as we’ll show here, these actions may do more harm than good.

Risks of abandoning a sound investment plan

At Vanguard, we frequently remind investors that their strategic asset allocation—the mix of stocks, bonds, and cash in their portfolios—is a key driver of their long-term investment results. If a participant’s allocation is appropriate for their goals, time frame, and other constraints, then even in times of uncertainty, no action is often the best action. (For more, see Vanguard’s Framework for Constructing Globally Diversified Portfolios). 

To appreciate the risks of abandoning a sound long-term investment plan for reactionary bond market-timing, imagine a participant with a broadly diversified bond allocation. As interest rates rise, he nervously eyes the mounting losses in the bond portion of his portfolio. Eventually, when rates rise enough,1 he moves his bond allocation into cash, hoping to avoid further losses. When the interest rate environment reverses and rates start to fall, he re-allocates to bonds, in fear of missing out on a rising bond market.2

As shown in Figure 1, our hypothetical participant has been moving in and out of bonds since 1998, depending on where yields are heading. The shaded areas represent periods when he abandoned bonds for cash. The unshaded areas represent periods when he left cash and reentered the bond market. Responding to interest rate changes in this way would have resulted in 15 trades over the past 25 years.

Figure 1. A hypothetical participant jumps in and out of bonds as interest rates change 

Periods in bonds or cash in response to changes in 10-year Treasury yields

Note: Daily yield is represented by the market yield on U.S. Treasury securities at 10-year constant maturity.

Source: Vanguard calculations using data from FRED®, Federal Reserve Bank of St. Louis.

Past performance is no guarantee of future returns. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index.

Figure 2 compares the hypothetical outcome of the participant’s reactionary interest rate timing with that of a buy-and-hold strategy, assuming a starting bond portfolio value of $10,000. If he had simply maintained his initial allocation to bonds and reinvested all coupon payments, his cumulative returns would have been 40 percentage points higher, leaving him with $4,200 more in his bond portfolio. Ignoring short-term rate movements and sticking to a sound investment plan for the long term would have been the better choice.

Figure 2. Staying the course with bonds would have produced better results  

Growth of a $10,000 bond portfolio over 25 years

Notes: The bond investment is represented by the Bloomberg U.S. Aggregate Bond Index through December 31, 2009, and the Bloomberg U.S. Aggregate Float-Adjusted Index thereafter. The cash investment is represented by the Bloomberg US Treasury Bill 1-3 Month Index. Market indexes are not investable and actual investments in a fund or similar product may be subject to management fees and other costs. The above scenario assumes all investment and transaction activity takes place within a tax-deferred account. Investments and transactions made outside of a tax-deferred account may be subject to additional costs.

Source: Vanguard.

Past performance is no guarantee of future returns. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index.

Why are market-timing strategies so difficult to implement successfully? Quite simply, too many stars must align to produce a positive outcome. In the case of the bond market, bond prices are affected by many factors other than interest rates. Predicting how bond markets will react to those factors, and then knowing precisely when to enter and exit a position, is next to impossible for the average investor. While the participant in this scenario may believe he’s avoiding the worst of the losses and capturing most of the gains, his trades continuously lagged changes in the 10-year U.S. Treasury yield. 

Plan design can help participants maintain perspective and discipline 

Even in the face of uncertainty, we believe that sticking to a sound investment plan and having realistic expectations can offer participants the best chance of investment success. Of course, a strategic approach to asset allocation works only if the allocation is adhered to over time and through varying market environments. (For more, see Vanguard’s Principles for Investing Success).

Fortunately, the counterproductive behavior described in this article is increasingly rare in the retirement plans we service. That’s in large part thanks to decisions made by plan sponsors like you. By embracing smart plan design and offering professionally managed allocations such as advice and target-date funds, you’re helping participants maintain the perspective and discipline they need to avoid behavioral derailers such as market-timing and performance chasing.

At Vanguard, we share your belief in a long-term, disciplined approach to investing. Together, we’re helping improve investment outcomes for your participants and keeping them on the road to financial well-being.

1 In this example, we approximate the reactionary trading behavior by assuming that a 1% interest rate increase would be enough to cause the participant to exit bonds in fear and switch to cash.

2 In this example, we approximate the opposing reactionary trading behavior by assuming that a 1% interest rate decrease would be enough to cause the participant to regain the confidence to exit cash and return to bonds.

  • All investing is subject to risk, including possible loss of principal. Diversification does not ensure a profit or protect against a loss. Past performance is no guarantee of future results.
  • Bond funds are subject to the risk that an issuer will fail to make payments on time, and that bond prices will decline because of rising interest rates or negative perceptions of an issuer's ability to make payments.
  • Investments in target-date funds are subject to the risks of their underlying funds. The year in the fund name refers to the approximate year (the target date) when an investor in the fund would retire and leave the workforce. The fund will gradually shift its emphasis from more aggressive investments to more conservative ones based on its target date. An investment in target date funds is not guaranteed at any time, including on or after the target date.

Kimberly Stockton 
Senior Manager and Investment Research Analyst

Michael Plink 
Investment Product Manager

Vivien Chen 
Investment Analyst

Jeff Seegers 
Investment Analyst