Recently, the Federal Reserve announced a rate increase for December and indicated its plan to raise rates three times in 2017. A bond investor may wonder about the impact this may have on the fixed income part of their portfolio. The basic tenet is true, interest rates and bonds prices have an inverse relationship. So as rates go up, bond prices come down. In this scenario, a bond investor can see the value of bonds decrease. However, there’s more to it than that.
It may be helpful to look at history. Since 1975, our economy has witnessed six rising rate environments. They lasted from two to five years with US Treasury bond rates increasing from 2.3% to 11.9%. In those six instances, the total annual return for the Barclays US Aggregate Bond Index ranged from 2.6% to 11.9%, with most of the annual returns in the 4% to 6% range. In short, no disaster for a bond investor.
So why do we hold bonds in our portfolios? Bonds can generate income, preserve capital, and lower the volatility of the portfolio. In a rising rate environment, the bond fund will reinvest into higher yielding bonds, which over time will pay a higher dividend. Over time, if rates continue to rise, bonds may become attractive due to the higher dividends.
Another important consideration is the bond maturity. The longer the maturity the more interest rate risk exists. On the other hand, although shorter maturities have lower risk they provide very little income. The key is to diversify your portfolio with short, intermediate and long term maturities which mitigate rate risks.
And, remember, rising interest rates indicate a growing economy and the equity portion of your portfolio may perform quite well during this period. But, other parts of the world may not perform like the US. The global economy is still on shaky ground. Rates may stall or even fall. In fact, history predicts that rates will fall next quarter. Currently, the US Treasury bond yield has had it largest quarterly increase ever, from 1.59% to 2.59%, a gain of 63%. Historically, five of the largest quarterly yield increases were followed by yields falling aggressively the following quarter, four out of five times. The strong US dollar could curtail exports and company revenues may fall. There are numerous things that could go awry.
For these reasons, you might be glad you’ve invested in bonds.