With the Federal Reserve in the process of raising the federal funds rate, the rate at which banks lend reserve balances to other banks on an overnight basis, some investors may be concerned about its impact on their bond portfolios. While it is true that bond prices move in the opposite direction of interest rates, an increase in interest rates may not have the negative effect on fixed income investments that some may expect. Investors in short-term bonds, in particular, might like what they see as yields increase. What’s the reason for that?
A Portfolio of Bonds
When investors buy a portfolio of bonds, in most cases they are buying a mix of bonds with varying maturities. As bonds in the portfolio mature, a bond manager purchases new bonds with the proceeds. In an environment of rising interest rates, the existing bonds in the portfolio might decrease in value initially, though any new bonds purchased will now have higher yields. Eventually the higher interest payments make up for the loss in the carrying value of the existing bonds, and in many cases the investor is better off in the end. This is especially true for a portfolio of short-term bonds because new bonds are purchased at a faster rate as the existing bonds mature.
Let’s take a look at a hypothetical portfolio of short-term bonds and compare its performance under two different scenarios. The portfolio starts with three bonds of equal value today:
- One bond that matures in one year and has an interest rate of 2.0%.
- One bond that matures in two years and has an interest rate of 2.5%.
- One bond that matures in three years and has an interest rate of 3.0%.
In one scenario, we’ll assume the market interest rates on one-year, two-year, and three-year bonds remain constant for the next four years. In another scenario, we’ll assume the market interest rate on bonds of each maturity increases by 1% at the end of each year for the next two years, and then remains constant after that.
We’ll find that the hypothetical portfolio in the constant rate environment outperforms through the first two years, though the rising rate environment is more favorable about halfway through the third year. After four years, a $100,000 investment would earn nearly $3,000 more in the rising rate environment.
This is a hypothetical example, though we have also seen rising rate environments play out like this for short-term bonds historically. The table below shows the total return on a 1-5 year bond index during a few rising rate periods in recent history. As you can see, an investor’s total return in each period remains positive while rates are rising. By the end of each rising rate period, the pickup in yield has a significant impact on total return in the years following.
If you are a short-term bond investor, don’t let the expectation of rising rates spook you. In fact, this is a good thing! You might see some modest price fluctuations if rates continue to rise, though you will benefit from the higher interest payments over time. Bonds play an important role in a portfolio for many investors, and you should be better off in the long-term by sticking to your short-term bond strategy.
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