The Bright Side of Rising Interest Rates

The Wall Street Journal has a useful interactive tool that can show investors how sensitive their government bond holdings are to changes in interest rates.

For example, here’s what things would look like if rates rose 1% from current levels on a number of different sovereign bonds at different maturity levels:

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And here’s what would happen if rates fell 1%:

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Expected stock market returns a can be tricky to nail down, but bond returns are fairly reliable in terms of how they react to certain variables such as current yields and interest rate movements.

The longer the duration and maturity of the bond or bond fund, the higher the variability of prices to changes in interest rates. This makes sense when you consider shorter duration bonds mature sooner, meaning you don’t have to rely as heavily on interest rate forecasts farther out into the future.

This past week was a good example of how this plays out in the real world. The yield on the 10 year treasury went from 1.83% at the close of business on Tuesday and shot up around 0.30% to 2.12% by Thursday afternoon as investors tried to figure out what a Trump presidency might mean for inflation and interest rates.

It’s still way to early to draw any conclusions about what this all means, but it is instructive to see how various bond maturities performed in this short window of rising rates.

Here’s a breakdown of the losses by various bond maturity ETFs:

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You can see that long bonds saw the biggest losses by far, while short-term bonds barely budged from the rise in rates. This also makes sense from the perspective of the current yields and trailing 5 year performance numbers:

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Again, the risk/reward relationship holds where higher yields tend to lead to higher returns (this is of course only a long-term phenomenon). And in return for this higher expected performance at the long end of the maturity spectrum you have to be willing to accept the possibility for larger losses.

Fixed income investors have been worried about rising interest rates for years now. Some think we could finally see a sustained rise from current levels. Like all forecasts, predicting the direction of interest rates is much harder than it sounds. No one can tell you where interest rates are heading or when they will start moving to get there.

But I think the concerns of what happens to bonds from rising rates are probably overblown.

Yes, bond investors will likely see more volatility and short-term losses than they’ve been used to in the past. But if interest rates just stayed at current levels forever, investors are assured fairly low long-term returns based on the current yields. That’s simply how bond math works. The only way bond investors are going to earn higher long-term returns is if rates rise so they can reinvest maturing bonds or new funds at higher yields.

Of course, this means that they will have to experience short- to intermediate-term principal losses to get there. This paradox of short-term pain for long-term gain is the usual trade-off seen in the investment world, but something many bond investors have been spared for some time now.

The size of those losses will be determined by the duration of your bond fund or portfolio.

Higher rates are still not a foregone conclusion. Markets are never that easy. But if higher rates do finally materialize, investors should welcome this development, not fear it. The only path to eventual higher fixed income returns is through higher interest rates.

If you have a time horizon of 5 years or longer, you should actually hope for a rising rate environment. You’ll be better off for it in the end.

Further Reading:
Bond Returns & Rising Interest Rates

 

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  • Well written Ben. I’ve been waiting for a long time to build a municipal bond portfolio, and I’m finally starting after the rate jack post election.

    I hope that higher rates are a harbinger for stronger earnings and economic growth. If you’ve accumulated assets, inflation is fantastic.

    Regards,

    Sam

    • Ben

      My guess is it won’t be this easy but building one up over time probably not a bad way to go about it.

  • patrick k

    Great charts. Here’s to higher rates for the “savers”, assuming of course that they artificially low.

    • Watch out for inflation flaring up too. If it does, and rates rise, the hidden tax may still eat up your gains.

  • “If you have a time horizon of 5 years or longer, you should actually hope for a rising rate environment. You’ll be better off for it in the end.”

    I think that would depend a lot on what kinds of bonds you own right now. If you own bonds with a relatively short maturities, rising rates could provide an opportunity to reinvest for greater investment income. If your bonds have very long term maturities, rising rates could mean (a) waiting a very long time to reinvest at higher interest rates, and/or (b) having to sell the long term bonds at a loss in order to reinvest at higher interest rates.

    Nick de Peyster
    http://undervaluedstocks.info/

    • Grant

      Yes, but probably not a good idea to be owning bonds longer than a 10 year term (more risk than return), or bond funds with a duration longer than a total market, or intermediate term bond fund, then you won’t have to wait longer than the duration (5-6 years or so) of the fund to be made whole again.

      • If you choose to own long term bonds or any security/market for that matter, I think it’s best to use a stop loss rule just in case the trend reverses on you.

  • UofODuck

    Investors have experienced a roughly 30 year decline in interest rates, which has been great for most bond holders. However, if a “reversion to the mean” is now underway, the benefit may inure mostly to short term investors and savers. For bond holders with 5+ year time horizons, the investing landscape is likely to be a great deal more complicated, depending upon the rate at which interest rates rise. It seems possible for a great many bond holders who invest in an open end bond funds to experience low, zero or negative rates of real return until rates rise to a more stable level – whatever that is in today’s world.

    • Considering only the yield portion of a bond or dividend stock can sometimes blind you to the price trend. And if the trend moves enough against you, the underlying yield may not help you recoup the losses all that much.