Rates and Reality Series: Are rising rates actually good for bond investors?

In this three-part series, Matt Tucker examines the relationship between interest rates and bond returns. His second post explores why your investment time horizon should change your viewpoint on rising rates.

Previously, we discussed how bond price gains driven by interest rate movements are temporary for buy-and-hold investors. This insight means that those who hold bonds for the long term really need to rethink how they view rising rates. For these investors, falling interest rates are actually a bad outcome, and rising interest rates should be cheered.

Unless you own a time traveling DeLorean, the 15% yields from 1981 that we discussed in the previous post are just not relevant today. What investors really want to know is how they should invest in the bond market now.  To answer this question, the first thing to do is to identify your investment horizon.  How long you plan to be in the bond market should determine how you view changes in interest rates.  To illustrate this, let’s look at a simple example.  Assume an investor purchased an intermediate-term bond fund with a medium level of interest rate risk.  There are three possible investment time horizons:

Investment horizon Time frame
Short-term 0-3 years
Medium-term 3-7 years
Long-term 7+ years

And while the investor is in the bond market, there are three separate forces that will determine the return:

  1. Initial yield—The current interest rate of the bonds in the fund.
  2. Bond price changes—The impact of interest rate changes on bond prices.
  3. Reinvestment rates—The level of future interest rates at which the investor can re-invest coupon and maturity payments.

Each of these three drivers has a different level of importance over different time horizons:

Factor Impact over time horizon
Short term Medium term Long term
Initial bond yield Medium High Low
Bond price changes High Medium Low
Reinvestment rates Low Medium High

Here’s what it looks like as a share of return drivers.

what drives bond returns, by time horizon

Chart is for illustrative purposes only.

Understanding the impact of time horizon

Let’s walk through each time horizon to get a better sense of what is going on.

Over a short-term horizon, when changes in bond prices will have the greatest impact on return, an investor definitely cares about the direction of interest rates. His or her investment is earning a yield, but it will play a lesser role in determining total return.  Reinvestment rates will have an even smaller impact as the investor won’t have many coupon payments to reinvest back into the market during their investment period. This time horizon lines up with much of the conventional wisdom about what drives bond market performance.

Over the medium term, we see that price changes are still important but less so, as prices will pull toward their par value as they approach maturity. Reinvestment is more important as the investor can invest more coupons, and likely some maturity payments, at new yield levels.  The initial yield at purchase has the greatest impact on the investors’ return. As a rule of thumb, the yield at which a bond or bond fund is purchased is the most important predictor of an investor’s return over a medium-term horizon.

The long-term investment horizon is when things really get interesting. The initial yield has only a small impact, because the bonds in the fund the investor purchased have turned over through time; as the rate environment changes, new bonds may be added at prevailing new yields.  Price changes driven by yield movements also have only a minimal impact, and once again will melt away as bonds approach maturity.

So what does drive the long-term investor’s return?

Reinvestment rates.  The reinvestment rate effectively determines the holding period return for each individual cash flow reinvested back into the market.  Specifically, at what yield can someone reinvest coupon and maturity payments that they receive?  Are rates falling, leading to lower and lower levels of reinvestment yield?  Or are rates rising, allowing the reinvestment of cash flows at higher yields through time?

In this scenario, rising rates can be an investors’ best friend, something I discuss in my next post.

Matt Tucker, CFA, is the iShares Head of Fixed Income Strategy and a regular contributor to The Blog.

Investing involves risk, including possible loss of principal.

Fixed income risks include interest-rate and credit risk. Typically, when interest rates rise, there is a corresponding decline in bond values. Credit risk refers to the possibility that the bond issuer will not be able to make principal and interest payments.

Investment comparisons are for illustrative purposes only. To better understand the similarities and differences between investments, including investment objectives, risks, fees and expenses, it is important to read the products’ prospectuses.

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