In our previous post, we showed what drives bond returns—namely a combination of the initial bond yield, price changes due to rate movements, and the reinvestment of coupons. For long-term investors, rising rates may actually be beneficial because they allow you to reinvest cash flows at higher yields in the future.
Most bond investors fall into the long-term camp. They are using bonds as part of a retirement plan or balanced fund allocation within a portfolio. Recognizing the impact of different interest rate environments helps these investors better contextualize their performance and see where they are relative to their investment objectives.
To make this simple we can think of there being four different types of interest rate periods. In practice, there’s a lot more complexity than what I am going to dive into here, but for our purposes, let’s go with these four:
In the above table, we assume that 1% represents low rates, and 5% represents high rates to illustrate simplified versions of 4 historical periods. These periods are listed in the preferred order for long-term bond investors.
Let’s unpack this a bit. As we discussed earlier, reinvestment rates drive long-term returns. Thus, top of the wish list should be a high and stable rate environment. Absent that, rising rates would be the next best option, as they provide future opportunities to reinvest coupons at incrementally higher yields. Next up is falling rates. This may feel counter-intuitive, as declining rates do drive prices higher. However, these prices ultimately pull back to par, and in the meantime future reinvestment opportunities are at lower and lower yields. Finally, low stable rates, where we have spent most of the past six years, is the least beneficial environment for long-term investors. It combines poor current yield opportunities with poor future reinvestment opportunities.
Where are we today?
We have been in scenario #4, the worst environment possible. Since the end of 2017 we have begun to transition to scenario #2, which for long-term bond investors is actually an improvement over scenario #3, the falling yield environment we saw during the great 30-year bond bull market.
Bottom line? If you are a long-term bond investor you should be excited that interest rates are beginning to rise. Higher yields mean higher reinvestment opportunities and higher returns over the long-term. For those bond math masochists who really want to dig into this topic, my colleague Steve Laipply and I recently published a paper on this. Enjoy.
For contrast, it makes sense to examine the short-term perspective beloved by the media and many commentators:
Short-Term Bond Investors’ Preferred Interest Rate Environments
|2||High, stable rates|
|3||Low, stable rates|
Within this time horizon, falling rates are indeed the best environment, as price gains can be realized in near term gains. Interestingly, high stable rates are still a very good regime, something that short-term investors have in common with long-term investors. Next up is low, stable rates, followed by the rising rate environment. All in all, the conventional wisdom holds true for a short-term investment horizon.
What can investors take away from this?
Know your investment time horizon. That will help you understand the implications of the rate environment and prepare accordingly. If you are in it for the long term, rising rates mean that the next decade may be better than the last–and a cause for celebration.