Debunking the Myth

Fixed income 101 is clear about the relationship between bond prices and yields, i.e., yields rise, bond prices fall, and conversely if yields decline, bond prices will rise.

In an environment of falling interest rates worldwide, it may seem that the least concern for bond investors should be rising rates. Yet, consider this: In December 2018, the US Federal Reserve raised the federal funds rate by a quarter of a percentage point, with guidance suggesting two additional hikes would be made in 2019.

A month later, in January 2019, the conversation changed to rate cuts. The lesson here is that the direction of interest rates can change quickly and investors need to be prepared for any eventuality.

Though rising rates will cause bond portfolios to decline in value, rising rates do not necessarily represent a significant long-term danger to bond investors. Here’s why:

• Price is not the major driver of a bond’s returns. The primary drivers of bond returns are price and coupon (or income). Over the long term, price return is generally a very small piece of total return for intermediate-term bonds. So while the initial price shock may be uncomfortable in a rapid rate rising environment, it is usually only a small contributor to returns in the long term.

• Rising rates have a smaller impact on shorter duration bonds. In a rising rate environment, short-term and intermediate-term bonds typically suffer smaller declines in value.

• Investors can benefit in the long term from rising rates. Fixed income investors can benefit from rising rates by reinvesting coupon payments into higher yielding fixed income securities. Moreover, an investor in a pooled vehicle can additionally benefit from rising rates as a result of new investment inflows into a fund from other investors, which are then used to buy higher yielding bonds, the income from which all fund shareholders benefit.

25-year average returns during rising rate environments

Source: Morningstar Direct as of 9/30/19. Investors cannot invest directly in an index. Past performance is no guarantee of future results.