The Effect of Fed Funds Rate Hikes on Your Bond Portfolio

Conventional wisdom says higher interest rates cause bond prices to fall. Big bond fund manager PIMCO, exchange-traded funds giant BlackRock, Inc. (BLK) and U.S. Bancorp (USB) say it as well.

But the federal funds rate is not a generic interest rate, and its influence on prices of bonds of varying types and maturities has been much less decisive than often imagined.

Understanding the Federal Funds Rate

The federal funds rate is the overnight interbank lending rate. In other words, it's the rate banks charge each other on loans with the nearest-term maturity.

The Federal Reserve targets a range on the federal funds rate consistent with its dual mandate of stable prices and maximum employment. Changes in the federal funds rate tend to ripple across commercial lending rates, and are an important economic signal for many investors.

The Limits of the Fed's Power

The price of a bond moves inversely to its yield. If the yield rises the price drops, and if it drops the price rises.

Since bond yields are a form of interest, it's easy to see how a rise in the fed's benchmark rate could raise other interest rates including bond yields, lowering bond prices. This has certainly happened in the past from time to time.

The Federal Reserve does not, however, directly set or target longer-term interest rates, which often move independently of the federal funds rate. In recent decades, the federal funds rate has correlated very closely with the one-year rate in U.S. Treasury securities but much less so with those on the 10-year Treasury bond.

Duration Explanation

That lack of correlation with longer-term bond yields may seem surprising, since longer-dated bonds are often said to be particularly vulnerable to higher rates.

Bonds with longer maturities do have a higher duration, which measures how much price moves relative to yield based on the weighted average of the expected flows of principal and interest. Higher duration means a bond price is more sensitive to changes in yield. The key point is that duration measures a bond's sensitivity to changes in the yield for comparable maturities, rather than that of the Fed funds rate.

The spread between the 10-year Treasury yield and the one-year Treasury yield has tended to drop when the fed funds rate has risen, dampening the effect on longer-term yields.

Defining Interest Rate Risk in Bonds

In 13 Federal Reserve rate hiking cycles dating back to 1965, the 10-year U.S. Treasury yield has tended to rise by an average of 20%, peaking three years later, by one reckoning.

One thing to note is that any such price declines are only relevant to bond market participants, while bondholders who hold a Treasury security to maturity get to collect for the expected coupon payments and can expect the return of principal in full.

Another qualification is that the historical data includes long stretches when Fed policymakers were much less forthcoming with information about their intentions than they have been recently.

For example, bond prices after March 16, 2022, reflected public knowledge of Fed policymakers' collective projections for a range of economic indicators over the next three years released that day, including their expectations for a series of increases in the federal funds rate.

Upon release, those projections helped shape public expectations quickly reflected in the prices of bonds and other financial assets. Bond prices could fall for any number of reasons in the future, but likely not because the Fed raises the fed funds rate at a pace policymakers have previously signaled.

Addressing Interest Rate Risk in Bonds

Past increases in the fed funds rate have coincided with positive returns in short-term bonds, Treasury and corporate. Surprise increases in the Fed funds rate have led to outperformance by the more risky corporate bonds over less risky ones.

Investors can lower interest-rate risk in their portfolios by moving to shorter-duration bonds and bond funds. They could also invest in floating-rate bond funds or in exchange-traded bond funds that hedge the risk of higher interest rates.

Were bond yields to rise sustainably, the near-term effect of lower bond prices could be offset by higher returns on future bond market investments. Selling bonds in anticipation of fed funds rate increases the market already expects is unlikely to prove rewarding.