We started 2016 with the idea that the Federal Reserve might raise interest rates four times in 2016. This expectation was set after the Fed increased interest rates by 0.25% in December 2015. Falling oil prices, volatility with the global economy and some disappointing economic numbers then led the Fed to put the brakes on any increases. A September rate hike was still thought to be a possibility this year, but in the end the Fed decided not to raise rates in their September meeting.
However, they did plant the seed for a rate hike before the end of the year – most likely in their December meeting after we get through the U.S. election. So with potential interest rate hikes on the horizon, I thought this would be a good time to review what effect rising interest rates have on bond investors. (For more, see: Don’t Buy What You Don’t Understand.)
Interest rates and bonds have an inverse relationship. That means when interest rates go up, bond prices fall. So as a bond investor, you risk losing money on your bonds. In a rising interest rate environment, bond fund investors will see principal values decline until rates level off or dip again. A diversified bond fund will reinvest interest payments into new bonds with higher coupons, meaning those investors will see larger interest payments with time.
Now that is the simple, straightforward explanation. However, it is more complex than that. The maturity date of your bonds and the type of bonds that you own will give you more insight as to how they will respond to an interest rate hike. Just like there are many different types of stocks out there – growth and value, small and large, international and domestic – there are different types of bonds. And those different types of bonds have responded differently in the past to interest rate hikes. (For related reading, see: Where Do Investment Returns Come From?)
One area investors should be aware of is the maturity of their bond portfolio. Longer maturity bonds have more interest rate risk. They will be more negatively affected by a rise in interest rates. One way investors have been trying to minimize this risk is to shift their bond investments to more short-term bonds, which have a lower risk to interest rate hikes. The downside of this move is that shorter maturity bonds tend to pay a lower interest rate.
Preparing for a Rate Hike
Should investors sell their bonds before interest rates go up? I don’t believe so. Investors need to understand how bonds work and why they own them. Bonds can have several functions in a portfolio. They can be used to generate income. They can be used to preserve capital. And they can be used to lower a portfolio’s volatility. Get a good understanding of what type of bonds you own, why you own them, and what risk is associated with those bonds if interest rates go up. This might lead you to adjusting your bond portfolio to be better prepared for rising rates, but it is unlikely that getting out of bonds all together is the right move.
Higher rates have not always imperiled the bond market. Since 1975, our economy has witnessed six rising interest rate environments. They lasted from two to five years with Treasury bill rates increasing between 2.3%-11.9%. In those six instances, the total annual return for the Barclays U.S. Aggregate Bond Index ranged from 2.6%-11.9%, with most of the total annual returns between 4%-6%. In short, no disaster for a bond investor. (For related reading, see: Why You Should Diversify and Rebalance.)