"Interest rates are at historic lows!"
I feel like I hear this every day as part of a radio ad on my way to work. Since the Federal Reserve pushed interest rates down in 2008 to encourage lending and soften the impact of the financial crisis, we have been waiting for the day that interest rates start to climb back up.
Any rise or decline in current interest rates has an impact on bond market values. Understanding how bonds behave in changing interest rate environments can help set expectations for portfolio performance in the future as well as break down common misperceptions.
What Happens to Bonds When Interest Rates Increase?
When interest rates increase, the value of other existing bonds (or bond funds) decreases - think of it as an inverse relationship. Here's an example: Let's say that you are the Bank of California, and you lend $100,000 to Joe's Bike Shop at a rate of 3.0%. Joe receives the money, but shortly thereafter realizes he needs additional capital. So, he reaches out to your friend, the Bank of Oregon. However, interest rates have gone up, and Joe's Bike Shop secures a similar $100,000 loan at a rate of 4.0%.
Now, let's say that you want to sell your loan to a third party and take the proceeds to invest elsewhere. Because interest rates have risen, your loan is less attractive than the equivalent loans on the market that carry that same risk (e.g. the Bank of Oregon who gets 4%!). To compensate for your lower interest rate, you will need to sell your loan for less than $100,000.
The same principle applies to your investments in bonds. If interest rates increase, the value of your bond decreases. How much a bond goes down in value will depend on several factors including:
1) How much interest rates have increased
2) When the bond matures
3) The frequency of interest payments
This is important to understand because some bonds (for example, short-term bonds with regular interest payments) typically hold up better than others when interest rates increase. We pay close attention to these factors to assure that we are not taking undue risk when it comes to rising interest rates.
The Positive Side of Increasing Interest Rates
There's good news too! An increase in interest rates gives you, as an investor, the opportunity to earn a higher yield. To understand how this works, let's take rebalancing your portfolio as an example. Periodic rebalancing is a strategy designed to help remold your portfolio to its proper allocation. Oftentimes, this means selling stocks and buying bonds. If interest rates have gone up, the newly purchased bonds should pay you a higher interest rate.
Moving Forward
While a rising rate environment poses some challenges, a properly invested portfolio can help mitigate some of those risks and position you to pursue your financial goals.
Investing involves risk including loss of principle. Bonds are subject to market and interest rate risk if sold prior to maturity.
No strategy assures success or protects against loss. Rebalancing a portfolio may cause investors to incur tax liabilities and/or transaction costs and does not assure a profit or protect against a loss.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.