Tell me if you have heard this one before: When interest rates go up, bond prices go down. The axiom is one of the most elementary bond concepts. And for many, it is the first thing they learn about fixed income.
So when investors hear that interest rates may rise, some assume it’s bad for bond investments and want to sell out of the market in a kneejerk reaction. Surprisingly, this might not be the wisest course of action for many investors. While this may sound a bit counterintuitive, rising interest rates could potentially benefit many investors. The key to unravelling this paradox is to look at how long an investor intends to hold their bond investment. To keep this discussion simple, I will focus on the impact of rising interest rates on bond funds, but it’s important to note that other bond investments may react differently or have different results than the examples presented below.
The long and short of time horizon
For bond investors with a short-term investment horizon, it is absolutely critical to think about rising interest rates. As rates rise, the price of a bond fund will fall, and if you are not planning to be in the market for very long, there is a good chance of a loss. Bonds with more interest rate risk will likely fall more in price. For this reason, an investment with a lot of interest rate risk may not be suitable for those with a short time horizon.
For bond investors with a medium- to long-term investment horizon, things are more complicated. To understand why, we need to peer into the mechanics of how bond funds work. Take an intermediate bond fund with a duration—interest rate sensitivity—of six years. If interest rates rise by 1% tomorrow, the price of the fund would typically fall by about 6%. That would probably feel very uncomfortable.
So far the old “rates up, bond prices down” axiom seems to be holding. But what happens in the subsequent days? If an investor held onto the intermediate bond fund, the amount of income the fund pays out might begin to rise. This is because bond funds tend to rebalance on a regular basis, to invest coupons, adjust to market movements, or take advantage of opportunities. As this intermediate bond fund rebalances, it can purchase bonds at interest rate levels that are now 1% higher.
Over time, more and more of the fund could become invested at this new higher yield level, resulting in rising distributions of income. These growing income payments begin to help make up for some of that 6% loss when rates rose initially. Assuming that nothing else happens, after six years an investor would have been made whole. The 6% price loss on the day that interest rates rose should have been fully compensated for by the higher level of income payout. And if the fund is held past the sixth year, an investor would continue to receive higher levels of income and begin to actually benefit from the rise in rates. The investor could be better off than if interest rates had not risen in the first place. A simple graphic to illustrate this point follows.
Impact of rising rates on a bond portfolio
In the end, the impact of rising interest rates is really a function of the investment time horizon. If you plan to hold a typical intermediate bond fund for a shorter period of time, a rate rise could have a negative impact. If you are concerned about rising rates, you should consider an investment with less interest rate sensitivity. But keep in mind: More interest rate sensitive bonds generally have higher yields, so moving to a shorter duration investment could result in less income. This is the cost of being less exposed to rising rates.
If you have a longer time horizon, a jump in interest rates could be favorable. That’s right, as a bond investor you may actually cheer for higher interest rates because of the potentially positive impact on fund distribution payments. This is especially true for those investors who look to their bond funds as a source of long-term income.
Next time you hear that interest rates might be rising, take a step back and think about your investment time horizon. You may realize that higher yields are a cause for celebration, rather than panic.
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