This article is featured in the spring edition of our 360 Insights Quarterly Client Newsletter.
Interest rates are rising. What does that mean to investors? Relax. If you hold short-duration, high-quality bonds, the news is generally good.
First, a caveat: Predicting future interest rates is a treacherous business. The Federal Reserve lowered the federal funds rate to near zero in 2007-2008 in response to the Great Recession. Since 2009, “experts” have been predicting rising rates, but those predictions failed to materialize until the end of 2015 (six years later). The lesson: Nobody can predict the movement of future interest rates with certainty.
The more important question: What happens to the bond funds in your portfolio if interest rates rise?
Interest rate (or yield) changes affect bond funds in two ways: a price effect and a reinvestment effect. The two effects interact with one another. But what really matters to investors is the net effect on their portfolio.
- Price effect. Bond prices and interest rates move in opposite directions. So if interest rates increase, bond prices decrease (and vice versa). Long-maturity bond prices are more sensitive to changes in interest rates.1 Price effects show up immediately in daily prices and quarterly statements, so people tend to focus on them.
- Reinvestment effect. The reinvestment effect is related to a fund’s turnover. Since funds holding short-maturity bonds must replace their bonds more frequently, reinvestment effects tend to be stronger for funds holding shorter-maturity bonds. Thus, the yields of funds holding short-maturity bonds tend to respond quickly to changes in interest rates. However, the reinvestment effect only shows up in quarterly statements when bond funds pay higher dividends.
On balance, short-maturity bond funds have generally done well in rising interest rate environments — the net effect has been positive. Long-term investors typically enjoy higher yields in the future. The funds themselves tend not to be very volatile, and since most of the bonds in such funds are held to maturity, the negative price effects tend to be negligible in the long-run.
Remember that bonds in a portfolio are intended to help reduce overall volatility. Shorter-term bonds can generally help dampen overall portfolio risk, regardless of what happens with interest rates. It is always a good time to review your bond exposure with your own financial advisor to make sure that it’s in line with your financial goals.
1 A bond’s sensitivity to changes in interest rates is known as its duration.