Rising Interest Rates and Bonds – It’s Not All Bad

March 8, 2018

You might be looking at your bonds, wondering why in the world they are negative.  Well, in bond investing, one of the biggest factors that impacts the price of bonds is interest rates. When rates go up, bond prices go down. This is something you may have heard before.

In recent weeks, bond yields spiked on expectations of a faster growing economy and inflation, creating fears that the Fed will have to raise rates more aggressively. Since January 1, the benchmark 10-year treasury yield has risen from 2.4% to nearly 3%, a level not seen since January 2014. Consequently, bond prices dropped, resulting in negative returns for most bond portfolios year-to-date.

Fed & Tax Changes

As the Fed unwinds its balance sheet, it is no longer a source of demand. Given the recent policy changes including tax reform and the effects those could have, some predict that the Fed will raise rates four times in 2018 and 2019. In hearing this, one can’t help but think of the proverb from Dante Alighieri’s Inferno, “Abandon all hope, all ye who enter here.”

On a brighter note, today’s environment does not resemble the gates of Hades, nor does it reflect the image of Robert Redford’s sinking boat in “All is Lost”. To know why, it’s important to understand what impacts long-term rates and how a higher-interest rate environment can be good for bonds.

Long-Term Rates

What impacts long-term rates? There are a number of factors, but the primary ones include:

  • Expectations on inflation
  • Future Fed policy
  • Expected growth in the economy and supply and demand in the market

In other words, while the Fed controls short-term rates, long-term rates are driven by the market.

Therefore, a more aggressive Fed doesn’t necessarily mean that long-term rates will also rise. Just look at 2017 as an example. The Fed raised short-term rates three times, yet yields on the 30-year treasury fell from 3.06% to 2.74% over the course of the year, largely due to foreign demand.

Income & Re-investment

It’s also important to note that over time, the income on bonds and re-investment of that income is what determines total return. According to Charles Schwab research, since 1976 over 90% of the returns from U.S. investment-grade bonds (represented by the Bloomberg Barclays U.S. Aggregate Bond Index) came from higher income payments. The effect of higher rates can more than offset price declines over time, if you are a long-term investor.

In examining that period in further detail, rates increased at an unprecedented rate. During this timeframe, the benchmark 10-year rose from approximately 7% to a high of just over 15% by 1981. The half a percent jump we have witnessed so far this year pales in comparison.

What happened if you had invested in bonds during this period? Vanguard did a study and took a $1 million hypothetical investment in the aforementioned index. The results? That investment more than doubled over that period, not exactly a horrible outcome.

Since no one can predict the future, the benefits of staying invested and taking a long-term approach continue to hold true. If one can just stay the course, hope is on the horizon.