As World War II loomed, the British government printed millions of posters with the tagline “Keep Calm and Carry On”. Intended for distribution in the event of a catastrophe and subsequent morale destruction, the posters were in fact never deployed. It wasn’t until the year 2000 that one of the posters was rediscovered and transformed into what has become a famous British slogan for stoic resilience.

Today, “Keep Calm and Carry On” should serve as motivation for bond investors. Australian investors were undeniably confronted by their greatest fear in 2013: From a yield of 3.24% on 1 January 2013, the 10-year Australian Commonwealth Government Bond jumped over 100 basis points (bps) higher to 4.34% by 31 December.

We appreciate investors’ concern over higher interest rates and long-dated bonds; PIMCO has navigated through every rate cycle since 1971. However, last year, even as the yield on the 10-year government bond rose, Australia’s local bond index grew by 2%. When rates rise, then, not all bond returns turn negative. Recall the period between 2009 and 2010 when the Reserve Bank of Australia (RBA) tightened monetary policy seven times – domestic bonds still produced sound positive returns (Figure 1). Clearly, bonds can provide positive returns when interest rates go up.

Quite simply, there is a lot more to bond returns than merely interest rate risk.

Understanding carry

To understand how bonds can generate positive returns in rising rate environments, it is important to understand the concept of carry. In simple terms, carry is a proxy for the total expected return an investor may earn from income and capital appreciation over their holding period. Bond portfolio managers are constantly seeking out sources of carry. Broadly, carry is associated with taking on: maturity risk, credit risk, volatility risk, curve risk or currency risk. While bond investors often fear maturity risk, or duration, other sources of carry are not necessarily dependent on interest rates. PIMCO’s portfolios express these sources of carry through hundreds of individual securities.

Some investors confuse “yield-to-maturity” with “expected return”. At PIMCO, we prefer a more inclusive estimate called “total carry”, which captures additional sources of potential return such as roll down, option-adjusted spread and currency hedging. For instance, the total carry of the Barclays Global Aggregate Index (A$ hedged) was 5.12% as at 31 December 2013 versus the yield-to-maturity of 2.12%. Total carry, while only an estimate and subject to change over time, is in most cases a far more accurate estimate of expected return than yield-to-maturity.

Positive returns despite rising rates

The concept of carry helps explain why bonds can be more resilient than anticipated when interest rates rise.

Consider a scenario in which the RBA cash rate is 5%. Following a surprise change in economic conditions, monetary policy is unexpectedly tightened by 100 bps, and in an unusual step, central bankers across the globe follow suit. These actions cause global yield curves to shift.

A uniform and surprise move in monetary policy typically causes duration-bearing securities to fall in price. Many assume an index such as the Barclays Global Aggregate (A$ hedged) with six years of duration, would decline 6% based on basic bond theory: When yields go up, prices go down. However, it isn’t that simple; whilst prices do move down, there is more to it – the carry commensurately increases over 12 months.

Take, for example, a five-year US Treasury bond (rated AA+), maturing 28 February 2019. Its total carry is 6.13% (yield-to-maturity plus yield pickup from AUD currency hedge), and its duration is 5.03 years. In line with a surprise 1% increase in the cash rate, the security’s expected return (the carry) increases by 1% to 7.13%. Subtract from this the duration effect that results from the move higher in the cash rate, or 5.03%. Over the 12 months, with a 1% tightening of cash rates, the total expected return from this security is an estimated 2.10%. Note that this very simple analysis is not incorporating the effects of convexity, which actually further add to the total expected returns.

A sharp move higher in rates can still result in a positive return over 12 months. Not only has capital been preserved, it has grown by more than 2% without any interruption to quarterly cash income payments.

For bonds to achieve negative returns, interest rates would have to rise an even more unrealistic 2%. Under this scenario, the implied return would dip to -1.93% for the five-year US Treasury security.

Diversifying sources of carry

Bond yields moved more than 100 basis points higher in 2013, and yet overall returns remained positive due to carry (Figure 3). This highlights the importance of building a bond portfolio with different sources of carry. A diversified portfolio invests in many hundreds of securities across multiple maturities, sectors, countries and credit qualities. With an active investment process that can take advantage of the $100 trillion global bond market, a diversified bond portfolio can better preserve capital and generate income throughout the interest rate cycle.

Bonds are not a short-term investment. Increasing interest rates can impair bond returns in the short term, though given time, the long-run return is likely to be higher. Active bond investors use cashflows to reinvest at those higher interest rates, generating greater rates of return.

Given our expectation for slow growth in the global economy, a large and swift increase in interest rates is unlikely, as central banks are likely to keep policy rates on hold, and the lack of credit demand means long-term borrowing rates are unlikely to be pushed significantly higher in the medium term. Moreover, notwithstanding the effects on bonds, sharply higher rates can have a negative impact across the board. Just as a sudden 100 bps rise in mortgage rates can make borrowers reluctant to spend, companies are unlikely to invest in new projects if the cost of funding outweighs the return on capital. The implications of a sudden and steep rate rise would thus be felt across asset classes, not just in fixed interest; there is an important difference with fixed interest, however unlike some other assets, high-quality bonds return your capital at maturity.

Many assumptions have been made in this stylised rising rates scenario − the largest is assuming that an investment manager would not identify, respond to or position portfolios for a period of rising rates. At PIMCO, we have been managing capital on behalf of investors for more than 40 years, through many rate cycles, and have demonstrated our ability to help preserve capital throughout the investment cycle.

When rates do rise, do not assume negative outcomes – Keep Calm and Carry On.

The Author

John Valtwies

Investment Due Diligence Group

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