Interest rates are going to rise, so it’s time for bond investors to bail on their fixed-income securities, right? Not so fast, says UBS, which in a recent report said the sharp rise in interest rates in mid-2013 had caused investors to draw two erroneous conclusions. First, that bear markets in bonds are always fast and severe. And second that bonds are not worth holding when interest rates are rising.

As we all know, during the past 30 some odd years interest rates have been on a southern trajectory that have culminated with rock-bottom rates in the current era of massive federal stimulus. But stimulus tapering has begun, and the economy is improving, so rates are bound to rise and investors are expecting the longstanding fixed-income bull market to go kaput.  

In an investment strategies insight report from its CIO Wealth Management Research division, UBS noted there were two major 20th century bear markets in bonds that lasted for multiple decades and were marked by interest rates that rose from low levels. While there are differences between today’s environment and conditions during the early years of the most recent bond bear market (1951 to 1981), UBS noted some important similarities. For starters, interest rates began to rise in the early ’50s after the Federal Reserve ended its post-WWII practice of buying Treasury bonds and allowed interest rates to float more freely.

And that particular bear market followed a period of rapid Federal Reserve balance sheet expansion with low inflation lasting several decades. Thus, interest rates rose only gradually for the first 20 years during that bear market, and total returns on both corporate and government bonds were modest but positive between 1951 and 1981. UBS noted that the worst performing 12-month period for bonds was less than half of what stocks lost during their worst drawdowns.

UBS recreated what it believes would have been optimal asset allocations during the ’51 through ’81 period and concluded that optimal portfolios remained well-diversified between stocks and high-quality bonds across all risk tolerances, and that portfolios lost efficiency as equity allocations rose above 75%.
In addition, presuming an ability to adjust bond portfolio duration, overall portfolio efficiency remained relatively stable across various levels of equity exposure. And regarding equities, UBS said investors should have favored small-cap relative to large-cap equity.

The upshot: UBS advises against going to equity-only allocations as interest rates likely rise in coming years, and believes that reducing bond portfolio duration makes more sense than shrinking the size of bond portfolios.