Interest Rate Increases and Bonds

| June 20, 2018
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Interest rates are rising, what impact will that have on the bonds or bond funds in my portfolio? It is a common question, and one that is being asked frequently as we look towards a year with two rate hikes already in force and the potential for more.

In general, rate increases are implemented when the economy is strong and in growth mode. On the whole, this is a good signal for investors, and usually for those who are net savers rather than net debtors. The impact that such a move will have on a bond portfolio is dependent on many factors, but is not necessarily an ominous sign.

There is as always a much greater risk of rate increases being a damaging market development if investors pull out of bond funds en masse. This would further depress prices, as fund managers would be forced to sell at lower prices to meet the demand. Absent panicky selling, the rate increase will actually lead to greater returns over the long run. As the bonds in a portfolio, or in a bond fund, mature they will be reinvested in newer issues at higher interest rates. Also, the interest payments from the currently held bonds will be reinvested at higher rates.

In 2015, Vanguard did the math for a hypothetical patient investor in intermediate-term bond funds subject to eight, quarter (.25) percentage point increases. This investor would earn less than without rate hike over the first few years, but then, within three years after the end of the rate increases, they would be ahead of where they would otherwise be without the increase. Since most investors holding bonds or bond funds have a longer time horizon they will be able to realize the eventual benefits of any rate increases.

In an increasing rate environment, other aspects of the bonds/bond funds held become more important. The duration of the bonds is one factor. Short term bonds will be less sensitive to rising rates as compared to bonds with longer durations. For example, a bond with a duration of 6 years that was subject to a 1 percent rate increase, might experience a 6 percentage drop in value, while a bond with a duration of 2 years might only drop 2 percentage points in the face of the same 1 percent rate increase. Another factor that should be examined are the fees associated with bond funds, so that if returns are depressed, excessive fees are not also eating away at the yield. As always the credit quality of the issuer is a factor and this simply becomes more important in an increasing rate scenario. A final thing to consider is that bonds with higher coupon rates, all other factors being constant, are generally better insulated from interest rate changes than those with lower coupon rates.  

How to address rate increases is dependent on the investor, their investment objectives, and their particular holdings. It can be seen as an opportunity to consider the attributes of the bonds and bond funds in a portfolio and make any adjustments thought necessary. It can also be an opportunity to wait for the benefits that increased rates will provide over the long term.

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