Since the stock market crash of 2008-2009, interest rates, especially the 10-year Treasury, have stayed historically low. Last quarter, the 10-year Treasury saw its largest rise since the end of 2013, halting a streak of five consecutive quarters of falling yields.
Most bond funds of all stripes, sizes and flavors have performed well since the crash. It’s been such a smooth ride, interest rates have stayed low for so long that it’s easy to forget bond prices don’t just go in one direction - up.
They can also go down in price as we’re seeing now. When interest rates rise, the prices of bonds fall, whereas when interest rates fall, the price of bonds rise. Wait, what?
If you’re confused, as most people are, about the inverse relationship between bond prices and interest rates, let me help.
For the sake of not getting too wonky and hopefully avoiding the risk of your eyes glazing over, below are some links to a few pages on Investopedia that help explain, mostly in plain English, how this crazy inverse relationship with bonds work and how that impacts your bond funds. Gain just enough knowledge to be dangerous.
Bond Funds Hedge Your Stock Market Risk
Many investors, whether individual or institutional, hold a diversified bond portfolio primarily to mitigate the volatility inherent in stocks or other risky assets, while others, especially those in retirement, hold bonds for the income they produce as part of a portfolio spending strategy as well. However, with yields presently at or near historic lows, more investors view the bond market as abnormally risky.
The majority of thought currently is that when interest rates rise, the fixed income portion of an investor’s aggregate portfolio may face volatility and loss. Coincidentally, the phrase ‘bond bubble’ is gaining currency among the talking heads of Wall Street. So with all that said, please allow me to put this potential bond risk in context.
As interest rates begin to rise, some say that will happen in September, I’m thinking more like December, many investors will see the price of their bond funds go lower. Ouch! After the pain wears off, your next thought may very likely be - I need to do something. What should I do? Sell my bond funds, move into cash? Help.
Per Vanguards plain talk bulletin - Interest Rates, Bonds & Misconceptions:
- Rising rates reduce the returns of most bond funds in the short term, but can boost returns in the long term.
- If you’re investing only for income (and can ignore fluctuations in your fund’s share price), rising rates won’t make much difference to you in the short term.
- What’s essential is that you understand why you own the bond fund.
Interest Rate Rise is Good News for Long Term Investors
Rising interest rates are good news for long-term investors and here’s why. Yes, your bond fund prices will decline initially, but between five and seven years later, the portfolios returns are higher than they would have been if rates had not risen. How does that work?
Here’s the secret sauce about rising rates when you have bond funds in your portfolio. Remember, your bond funds generate monthly interest income. That interest income is reinvested monthly at higher yields and over time, those higher interest rates produce higher yields for your bond funds.
Summing Up: The Right Response
If you’re holding bond funds as part of a long-term asset allocation, rate changes are rarely a good reason to change your investment plan. In fact, as long as you reinvest your interest income-or invest new cash-higher rates can enhance your long-term total returns. And if you’re investing for income, rate changes won’t make much difference in the dollar amount of a fund’s income distributions, at least in the near term.
What about getting out of bonds before rates rise, then getting back in after rates have settled?
That approach sounds good in theory, but in reality, rate changes are impossible to predict with accuracy.
The best reason to take action is if you discover that your bond fund no longer fits your needs. Maybe your circumstances have changed. Or you may decide that you picked the wrong fund. Maybe you invested in a long-term bond fund, tempted by its relatively high yield, and now find you took on more risk than you bargained for. If you can’t tolerate any fluctuation in the amount of your principal, your best options are money market funds.
Whether interest rates are rising, flat, or falling, the same principle should govern all investment decisions. Know how each investment fits into your overall financial planning strategy and why you own it. If you can answer those questions, rate changes are just part of the markets’ daily spectacle.
So tune out the noise as much as possible and enjoy the rest of your summer.