If the Fed starts raising rates, we’ll celebrate!
“Are you crazy?”
“Have you forgotten that bond prices fall when rates rise?”
“Should I worry about losing money?”
The answer to all those questions is NO! Conventional wisdom says rising rates are bad for bond investors − yet the story is not that simple or negative.
We welcome the Fed to start raising rates. Here are three reasons why investors shouldn’t fear rising rates and instead celebrate them:
Rising rates = higher income
When rates rise, the income earned on existing bonds can be re-invested in new bonds that earn higher rates. To illustrate, let’s look at a hypothetical investor, Barry, who holds $1,000 of a 3% average yield bond portfolio with a 3-year duration.
- If rates stayed constant at 3% for five years, Barry’s $1,000 would return a little more than 3%, which consists of 3% yield reinvested over time (the blue line in the graph below).
- If we assume that rates rose by 1.25% immediately after Barry bought his bonds, his bond portfolio would suffer an initial loss, but at the end of five years, his portfolio would be worth more (see the green line) than if rates had remained the same.
- The decline in bond prices from rising rates is more than offset by the reinvestment of the income at higher rates – and resulted in more income and higher portfolio value over five years.
RISING RATES IMPROVE BOND RETURNS OVER TIME
Growth of a bond portfolio in a rising-rate environment
Thus, rising rates are good for long-term investors who invest dividends and don’t plan on liquidating their bonds over the near term.
Rising rates = global economies are growing
Generally, interest rates rise when an economy is expanding. That’s good news for investors: in a growing economy, markets benefit from increased consumer and capital spending. If and when a central bank raises rates, it would indicate that an economy is making great strides in healing from the global financial crisis.
Rising rates also typically support rising corporate profits and stronger balance sheets. They could also signal that inflation might finally be returning. When rates drop, that could signal deflation, which can be disastrous for an economy (like Japan); one where prices fall, the economy slows down and cash becomes a valuable asset.
Though the ideal investment environment requires a careful balance between rampant inflation and dangerous deflation, as the former Federal Reserve Chairman Ben Bernanke said in 2002, “Prevention of deflation remains preferable to having to cure it.”
Returns aren’t always negative!
Contrary to what many investors fear, rising rates don’t result in negative returns – provided that investors don’t capitulate during the rate rising cycle. This chart from Morningstar Direct shows how bonds performed during the last three rising rate cycles:
When investors choose a diversified portfolio of bonds, their returns would be positive in each rate rising period (start to finish), especially when bonds were held until calendar year-end of the rising rate period, barring the U.S. High Yield Corp Bonds asset class.
This data challenges the conventional wisdom that rising rates always create a negative outcome. The results would be bad, of course, if investors capitulate at the start of the rate rising cycle when they see their initial negative returns, which perhaps is why the conventional wisdom has been so widely accepted as fact. The data supports staying invested in a diversified bond portfolio, especially since it’s virtually impossible to time the market and know when to move between cash and bonds. For patient investors, the short-term losses due to a drop in price is typically temporary and rising rates generally yield positive returns over time.
For these reasons and others, yes, we would celebrate rising rates — it would mean more good news than bad news.
Given the complexities of the low returns and a potentially volatile bond market, we strongly urge investors not to employ market timing tactics. Going to cash fearing rising rates is typically not a winning strategy, especially since it’s difficult to predict when and by how much rates would rise. History is rife with pundits and unhappy investors that have failed to accurately forecast prior hikes in interest rates.
We recommend that investors be aware of the bonds they own and understand both the short-term and long-term implications of rising rates on bonds. To learn more, here are two additional articles that detail the steps GV has taken to help mitigate risks in bonds:
Finally, please remember that no investment – including bonds – is without risk. We welcome your questions – connect with us here!