You’ve probably heard the prognostications: “Interest rates will rise in the coming years, so bonds are not the right choice now for your portfolio.” There are several problems with this reasoning. The first is that it treats all bonds the same, when they actually comprise a range of assets that vary along dimensions such as duration and credit quality.
For instance, high-yield issues, particularly convertibles, often behave like equities, while Treasuries tend to be negatively correlated with equities. Active management among these different types of bonds is capable of producing returns in very different interest rate environments, rising or falling.
There is also more to the return of a bond than its capital gain or loss. Income is a key consideration. Over the last 15 years, when interest rates have been generally falling, income has been the primary driver of bond performance.
As the chart to the right indicates, from 2000 through 2014, the Bank of America Merrill Lynch High Yield Master II Index derived all of its total return from income (yield), with capital losses detracting 3% from returns.
And rising rates can enhance the return from income. This brings the potential of overcoming capital losses when the bond portfolio is actively managed and management is free to move along the spectrums of duration and credit quality.