Contrary to what we often hear and read, rising interest rates are actually good for long-term bond investors. The financial media has succeeded in recent years at creating anxiety among investors about the effect rising interest rates will have on bonds, causing some investors to question the role of bonds in their portfolios. While the old adage “when interest rates go up, the value of existing bonds go down” holds true, it is only part of the story.
The other part of the story is that as rates go up, so too do the yields on new bonds added to the portfolio. A bond fund is always reinvesting the interest payments from the bonds it holds, as well as reinvesting the proceeds of maturing bonds into new bonds. When interest rates rise, that money is being invested in new bonds with higher yields, which eventually boosts the fund's return. It is simply a matter of time before the increased yield earned more than makes up for the initial market value loss the higher rates caused.
Let’s look at a hypothetical example* using some simplified bond math. Say an investor has a $1,000,000 bond portfolio invested in a low-cost bond mutual fund with a duration of approximately six years and a current yield of approximately 2.5%. Duration is a gauge of a bond fund's sensitivity to changes in interest rates, and is the best way to estimate how much of a decrease a bond fund’s price may take when rates rise. The duration measure of six years means the fund's price would drop roughly 6% for each one-percentage-point rise in interest rates. The Federal Reserve’s long-run (post-2019) target for the Fed Funds rate is approximately 2.5% higher than the current rate. To magnify the effects for illustrative purposes, let’s assume the whole 2.5% rate increase happens at once. Following is the math and a chart summarizing the results:
Source: Chart and Graph: Portfolio Solutions®; Data: Morningstar
Even in this extreme example, the bond investor would be better off with the increased interest rate prior to year seven. The general rule is if the duration of your assets (the bond fund) is shorter than the duration of your liabilities (the completion of retirement funding for most), then you benefit from rising rates.
Some investors incorrectly believe they can time bond markets by selling bonds before the Federal Reserve raises rates, then buy them back when they think the Federal Reserve is done increasing rates. The problem with this logic is that the Federal Reserve controls the Fed Funds Rate - the overnight rate on bank funds - and it has little direct effect on the price of most bonds. The rates bond investors should be concerned with are Treasury rates. The market for U.S. Treasury securities is by many measures the largest, most active debt market in the world, with enormous amounts of Treasury bonds traded every business day. Treasury bond rates go up and down daily based on the activities and beliefs of many market participants. Market expectations for the current and future actions of the Federal Reserve represent one of hundreds of other factors already priced into this market on a real-time basis. Correctly forecasting treasury markets is as difficult as trying to forecast the stock market.
Regardless of whether rates rise or not, bonds will always play an important role in a portfolio. Bonds are unique in that they have historically exhibited negative correlation with stocks. This means that as stock values decrease, the value of bonds tend to increase, and vice versa. Because of this characteristic, bonds tend to dampen the volatility of the stock market. Rather than avoiding bonds, one should instead be thinking about how best to allocate their portfolio between stocks and bonds. Ideally, investors should own the right balance of stocks for their individual situation to get the optimal long-term growth historically provided by stocks AND enough bonds to attempt to provide some stability and income for their portfolio and to mitigate the downside when stocks periodically slump.
At Liberty Wealth Advisors, we work closely with our clients to determine the proper mix of stocks and bonds for their portfolio. We believe investors should take only the amount of tolerable risk that is necessary to achieve their goals, and no more.
If you have questions about your asset allocation, the role of bonds in your portfolio, your investment time horizon or any other topics please don’t hesitate to contact Mike Parry. It is our pleasure to serve you.
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No independent analysis has been performed and the material should not be construed as investment advice. Investment decisions should not be based on this material since the information contained here is a singular update, and prudent investment decisions require the analysis of a much broader collection of facts and context. All information is believed to be from reliable sources; however, we make no representation as to its completeness or accuracy. The opinions expressed are as of the date published and may change without notice. Any forward-looking statements are based on assumptions, may not materialize, and are subject to revision.
All economic and performance information is historical and not indicative of future results. The market indices discussed are unmanaged. Investors cannot directly invest in unmanaged indices. Please consult your financial advisor for more information.
Additional risks are associated with international investing, such as currency fluctuations, political and economic instability, and differences in accounting standards.
While diversification may help reduce volatility and risk, it does not guarantee future performance.
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*The hypothetical investment results are for illustrative purposes only and should not be deemed a representation of past or future results. Actual investment results may be more or less than those shown. This does not represent any specific product.