With interest rate hikes and indications that there will be further increases in 2018, we’ve been receiving questions about the impact of rising interest rates on a bond portfolio. In this video, Pure Financial’s Director of Research, Brian Perry, CFP®, CFA® answers the question, “what will happen to my bond portfolio when interest rates rise?”
Interest rates have been on an upward trend lately, and because of that, we’ve been getting more questions about the impact of rising rates on a bond portfolio. And the short answer to the question, “what will happen to my bond portfolio when interest rates rise?” is simply this: it depends.
And the reason that it depends is that not all bonds are created equal. Some bonds have very high levels of sensitivity to interest rates. These might be long-term bonds, 30 years or more. Other bonds have very little sensitivity to interest rates. Maybe these are one-year bonds or two-year bonds.
And the key when it comes to managing a bond portfolio is matching the bonds that you own to your objectives. Most individuals will find that their objectives are best suited by short and intermediate term bonds. Maybe those are anywhere from one year to 10 years. Other individuals may own longer-term bonds, but that comes with the realization that they will be more susceptible to rising interest rates.
When interest rates rise, however, there are two impacts on a bond portfolio. The first is that, in the short run, prices do fall. As interest rates go higher, bond prices decline. But the second impact is sometimes hidden, and it’s simply this: over time in a rising interest rate environment, the income from a portfolio increases. That’s because bonds are constantly maturing, or kicking off income streams in the form of coupon payments. As that income and those maturities are reinvested at ever higher interest rates, the yield on your bond portfolio increases. And so what many people may find is that, over the course of an interest rate cycle, the path of their bond portfolio will look something like a U.
Initially, the value will decline as price losses from the bonds outweigh any gains in income. But over time, those higher income levels offset price declines and result in a net asset value, or a value of your bond portfolio of perhaps equal to or greater than where you started. Ultimately, in fact, rising interest rates are an investor’s friend because of this: an investor has a choice of whether or not to take a loss in a bond portfolio if it’s due to an increase in interest rates. And what I mean by that is that when a bond defaults, if it’s a lower credit quality bond, an investor has no choice whether or not to recognize the loss. And that loss is a permanent impairment of their capital. But with interest rates, because of the fact that bond proceeds can be reinvested into the portfolio, interest rate movements are self-correcting. Investors have a choice of whether or not to recognize losses. And if they don’t recognize their losses, then any temporary declines are simply that: a temporary impairment of their capital. And so rising interest rates are nothing to fear, provided the average maturity and the composition of your bond portfolio matches your goals.
If your time horizon and your financial goals match your bond portfolio, in fact, rising interest rates are your friend. Think about it this way. What’s going to provide more income: higher interest rates or lower interest rates? The answer, of course, is self-evident. And if you have a financial goal that involves getting a certain required rate of return, higher interest rates are going to move you closer to that financial goal. And that’s why starting with a financial plan which identifies your goals, following that up with a bond portfolio – if you own bonds, if they’re appropriate for you – that matches your goals, and then staying the course in those high-quality bonds is the best thing that most investors can do, and is going to give them the highest opportunity to meet their financial goals.
So again, rising interest rates and some of the rhetoric that comes from it, especially out there in the media, some of the paranoia, some of the hyperbole – can sometimes prompt fear that “oh my goodness, my bond portfolio is going to collapse in value.” But the truth of the matter is that if your bonds are short and intermediate term, and if they’re appropriate to your time horizon, rising interest rates are your friend, not your enemy, and are going to increase your odds of meeting her financial goals.